Evaluating Sector Rotation
Key to successful sector investing is the ability to detect emerging trends in sector rotation early, and either the subsequent trend reversal or else identify and switch to alternative sectors offering better return potential.
MarketScalpel's quantitative and visual top down market by sector analysis tools enable clients to rapidly grasp shifting patterns of sector rotation, and position themselves accordingly.
Defining and Measuring Sector Rotation
We use the term in the broadest sense to refer to material investor flows in and out of sectors, which represent the building blocks of trend. Our preferred metrics are price movement and MarketScalpel's proprietary volume confirmation rankings based on our sector Money-Flow and breadth data.
However, we do not endorse what we refer to as the conventional view of sector rotation, which implies that a semi-automatic series of sector allocation shifts through the business cycle generates alpha.
The Conventional View
The conventional view of sector rotation was perhaps first comprehensively articulated by Sam Stovall in the S&P strategist's 1996 book "Sector Investing".
It represents the belief that investing in certain sectors at different stages of the business cycle can deliver superior semi-automatic returns relative to a purely passive strategy. The preferred sectors through the various stages of the business cycle are laid out for reference in graphic and table form.
We have been skeptical of this view for some time. Soon after our analytical framework started delivering structured sector analysis it became clear that intermediate broad market declines tend to substantially rotate selling pressure 360 degrees around sectors, with few if any ultimately left unscathed.
Patterns of shifting sector rotation resulting in upside and downside market leadership can certainly be discerned within both declines and advances. However, experience suggests these rarely exhibit more than superficial resemblance to the no doubt sound industrial-based logic theorized to exist by conventional sector rotationists
A Formal Critique of the Conventional View
In a 2007paper professors Stangl, Jacobsen and Visaltanachoti tested a conventional sector rotation strategy investing in prescribed sectors through the course of the business cycle using almost 60 years' data.
They found this delivers only a 2 percent alpha allowing for timing business-cycle stages with perfect hindsight (using NBER dates) and ignoring any transaction and market impact costs. Adjusted for real world conditions, including the vagaries of forecasting the economic cycle and slippage, these returns are at best marginal and offer a poor Sharpe ratio relative to a passive strategy.
Deciphering Market & Economic Intelligence
In spite of the marginal excess returns delivered by the conventional sector rotation strategy, there are nevertheless compelling grounds for active market participants to stay abreast of themes suggested by the model.
For example, our top down market-by-sector visual analysis tools rapidly revealed that consumer non-cyclical sectors, including parts of Healthcare, were relatively strong from the middle of the 3rd quarter of 2007, in the face of otherwise broad-based weakness. These areas were nevertheless not immune from the early January downdraft but this intelligence nevertheless served to caution that a defensive stance was being adopted.
In other words whereas the evidence for the ability of the conventional sector rotation model to deliver excess returns is flimsy, it can provide valuable information regarding the market's assessment of the economic outlook. As such the chances of correctly determining the stage of the business cycle can be significantly improved, allowing for timely changes in investment strategy and/or asset allocation when the fundamental outlook changes.
Enabling Dynamic Sector Allocation
We believe there is no readymade sector rotation roadmap that delivers automatic investment outperformance.
However, our Market Navigator sector research platform offers superior tools for identifying sectors where rotation offers the best potential to capture returns regardless of the stage of the business cycle.