A Simple Way To See Sector Rotation In Action

by: Erik Conley

Having an awareness of which sectors are rising and which falling is valuable for investors.

It doesn't have to be complicated or tedious to stay on top of it.

I use 3 charts for this task, and it takes me about 10 minutes to update them.

I've written before about Situational Awareness and how important it is to a serious investor. The good news is that most investors fly by the seat of their pantaloons, making decisions based on little more than heuristics and emotions. That fact alone is one of the reasons there is still plenty of Alpha in the market. And after all, isn't that what we are all seeking?

Situational Awareness is a broad subject, but today I want to focus on sector rotation as one aspect of it. I do investment coaching for a living, and I've noticed that only a small minority of my clients come to me with even a rudimentary understanding of sector rotation. I take the time to bring them up to speed on this topic because I think it's important information to have.

The other thing I've noticed is that the few clients who do understand and use sector rotation usually spend hours and hours every month researching and charting and worrying about whether they are doing it right. I try to get them to ease down a little.

Having an awareness of sector movements is valuable, but it's not the Holy Grail by any Stretch of the Armstrong. Truth told, I spent many years trying to develop a sophisticated model that would capture the information value of sector movements. I know whereof I speak, in other words. But now that I'm a crusty old veteran of the business (your words, not mine), I've learned to simplify the process and get a better return-on-effort.

I use a simple 3 time-frame charting system to track the relative movement of sectors. There are only 10 of them, so it's not that hard to do. This first chart shows the 1 year performance of each of the 10 sectors. You can use 2 or 3 years if it suits you, but the concept is the same.

This chart establishes what I think of as the "base rate" of sector rotation. We will build on this as we go along, but for now it's clear that financials, tech, and industrials have been leading the market higher over the last 12 months.

The second chart narrows the timeline from 1 year to 3 months.

This is where it starts to get interesting, at least to an equity guy like me. The first thing I notice is that financials, which were the 1 year winner, are slightly behind the market over the last 3 months. What does this mean for financials? Is their run over? Are they being replaced by a different sector? Or are they simply taking a breather?

We can't know the answers from these two charts alone, but I sure want to do a little digging into what's going on here. I might want to cut back on my exposure to financials if it looks like this retreat is justified by fundamental forces.

Technology and industrials are maintaining their leadership, so there's nothing to be concerned about there. And energy continues to lag the field, for obvious reasons. Based on these two charts, I wouldn't touch energy with a ten foot pole.

I think you get the gist of this exercise, so let's move on to the shortest time frame that matters in the scheme of things - 2 weeks.

Most of the value we can squeeze out of this chart comes from its confirmation or contradiction of the trend changes we saw in the 3 month chart.

Hey- financials are back, baby! So maybe they just temporarily lost their way as they were coming back from the Dodd-Frank party. Industrials and tech are still ahead of the market, so I'm comfortable staying invested there. But we have a new player on the field - health care. It's way too soon to christen a new leader, but this chart puts health care on the radar for further tracking.

O.K., you get the idea. Simple is often better than complex when it comes to the amount of time and effort you devote to research. I find these three charts more than adequate for my needs in the sector arena of investing.

As most of you have undoubtedly learned by now, it's very easy to go down rabbit hole after rabbit hole when you're trying to find your path as an investor. Remember what I said earlier about ROE, return-on-effort. Unless you're a complete dilettante (Google it) or a trust fund baby with nothing but free time, you have to be selective about how you spend your research time.

I hope this helps, at least a little bit.

Disclosure: I am/we are long XLF, XLK, XLI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.