Tactical Sector Rotation Strategy: 2021 Review And Outlook

Jan. 31, 2022 9:00 AM ETSPY, IVV, VOO, XLF, XLE, XLI1 Comment

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Summary

Despite various threats to the economy, US equities grew in 2021, and the S&P 500 finished the year near a record-high level.
Since the previous business cycle shift, our Tactical Sector Rotation Strategy has outperformed the S&P 500 during this period.
As we move into 2022, the economy is expected to enter a new business cycle. New sectors are recommended to benefit from this shift.

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Introduction

2021 was a year of recovery following a stressful 2020, as investors had high hopes that the business environment would get back to normalcy. The vaccine rollout and the easing of COVID-related restrictions led the economy to recover despite the threats of new variants. Markets reached their pre-pandemic levels again last year, which increased the fears of an overheated economy characterized by skyrocketing inflation fueled by supply chain disruptions and a below-normal unemployment rate.

The investment strategy blends ETFs from various sectors according to the different phases of the economic business cycle. Our Tactical Sector Rotation strategy identified in November 2020 that the economy was heading towards the early phase. Since the signal of that date, the portfolio has increased by 74% by the end of 2021 compared to 48% for the SPY.

The investment strategy is a rule-based investment approach that has been backtested and generated above-average annual returns. For more clarification regarding the strategy's approach and drivers, you can check our previously published articles: "This Sector Rotation Strategy Made 17% Each Year Since 1991" and "This Sector Rotation Strategy Has Delivered Each Year Since 1991 (Part 2)", where we introduce and explain how the model estimates the change in the business cycles and what the corresponding sectors are for each phase.

In today's article, we will analyze the factors contributing to this outperformance in 2021 and assess the outlook for 2022, in order to be prepared for the next shift in the economic business cycle.

2021: A Year of Volatile Recovery

Many analysts were astonished by the speed of market recovery in 2021, with all sectors showing positive returns. Notably, the worst-performing sectors in 2020, energy and financials, turned out to be the best-performing ones in 2021. Furthermore, as the market soared throughout the year, the S&P 500 reached new highs. The SP500 TR finished 2021 with a 30% return. The chart below depicts the performance of the major sectors:

2021 can be divided into two parts. In the first half of the year, many positive factors bolstered the markets, driven by a surge in demand as consumer expenditure rose following different stimulus packages and solid corporate results, in addition to the global economic reopening. On the other hand, other factors weighed on the recovery path and growth outlook in the second half. Increased inflationary pressure was caused by high liquidity among consumers, combined with major supply chain disruptions across the globe. This led to a boost in sales, but inventories were at their lowest levels. As such, the term "transitory inflation" faded away, and the CPI started registering its highest rates in decades.

Sector Rotation Performance

Since November 2020, our strategy called that the economy would switch to the early phase, characterized by increasing economic production and profitability. According to the strategy, three sectors were expected to outperform throughout this phase: energy, financials, and industrials. As shown in the chart below, energy and financials have outperformed the market since then and all through 2021, while industrials underperformed.

We can check the evolution of the model portfolio during this period to further analyze our hypothesis's efficiency.

The strategy outperformed the market during all of this period. Assuming the same amount was invested in the strategy and in an ETF replicating the market, the tactical sector rotation strategy would have produced 74% returns over 14 months compared to 48% for the market portfolio. Thus, the strategy was able to generate 26% of excess returns.

Additionally, if we check the monthly performance during this period, the strategy outperformed the market in 8 out of 14 months.

The main factors contributing to the outperformance of the chosen sector combination are the following:

Energy: The energy sector recovered from a major selloff in 2020 when oil futures prices turned negative at some point due to oversupply during a global shutdown. Conversely, the sector was the top performer in 2021 as investors' optimism about a future recovery grew, and oil prices rose dramatically following increasing demand. Another major factor is that investors usually devote more capital to stocks sensitive to economic growth.

Financials: In 2021, consumer sentiment improved as the economy recovered, and high liquidity was available following several stimulus packages to sustain economic activity and avoid a deep recession. As inflation registered high rates, the Fed decided to speed up the pace of tapering its asset purchases, and interest rate hikes were expected in 2022, which will help the financial sector expand its profitability margins as rates increase. Expectations of a steeper yield curve and new mortgage lending activity were being priced in by the market, contributing to a rally in the financial sector.

Industrials: As the recovery gained momentum in 2021, manufacturers were able to get back on track as industrial output and capacity utilization regained their pre-pandemic levels. Nevertheless, significant headwinds weighed on the sector's performance, like labor shortages, supply chain disruptions, increased commodity prices, and various COVID variant disruptions.

Current Holdings are Still Outperforming

Furthermore, the financial sector is still outperforming the market on a YTD basis. However, bank earnings released earlier this month showed that the Fed's new position is weighing on some businesses in the sector.

As for industrials, the sector is also outperforming the market. However, global industrial activity is believed to have peaked already, and the manufacturing activity of developed economies may weaken in 2022.

A New Business Cycle on the Way

The outlook for 2022 is still uncertain, given various threats. The Fed's actions will be the biggest determinant of this year's economic state, as the intensity of interest rate hikes and the withdrawal of liquidity injections elaborate. However, supply chain disruptions, COVID variants, and labor shortages will limit the intensity of the Fed's actions in order to keep the economy growing and avoid a new recession. As a result, the market is expected to face the pandemic in 2022 with a gradual decrease in financial support.

Our strategy's investment decisions are driven by the change in the Leading Economic Indicator (LEI). Accordingly, we believe that in the following months, as the Fed starts increasing rates and as the LEI starts stabilizing or growing at decreasing rates, the model might indicate a business cycle change towards a new phase. Thus, new sectors are expected to be held in the coming period. Various macroeconomic factors can be examined supporting a potential change in the business cycle. For example, consumer sentiment is at its lowest levels since 2012, implying that consumers considering the current period as a good time to purchase large household goods has decreased substantially.

Conclusion

Investors use different investment strategies to benefit from the changes in business cycles. However, many struggle to forecast the timing of the business cycle shift or estimate the ending of a current phase. Our sector rotation strategy, driven by the yearly change in LEI, proved, so far, to gauge the change in economic phases effectively. The rebalancing towards energy, financials, and industrial sectors in November 2020 helped us generate an above-average return and outperform the market throughout 2021. As we move further into 2022, new difficulties and challenges threaten the investment environment, and a new business cycle is expected to replace the early phase. Moreover, last year showed that making investment decisions in an uncertain environment is challenging and might be faced with various unpredictable events triggering sell-offs and increased volatility. Accordingly, investors might benefit from our Tactical Sector Rotation Strategy by having a forward-looking approach to the next business cycle.

This article was written by

Francois Soto, CFA

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François Soto is Factor-Based Asset Management’s President and Portfolio Manager. He is leading the investment process for various model portfolio strategies while also overseeing equity research. Before creating the firm, François accumulated 15 years of experience working for various financial institutions. François holds a MBA degree specializing in Finance from HEC Montreal (2011) and is a CFA charterholder (2016), a FRM charterholder (2010) and a CIM charterholder (2010).

Disclosure: I/we have a beneficial long position in the shares of XLE, XLF, XLI either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.