Strategic Market Analysis: Sector Rotation

Sector allocation is a key driver of investment returns.  

An understanding of sector rotation themes can deliver outperformance by enabling market participants to anticipate shifts in sector appetite ahead of the crowd.

It also affords active investors an invaluable strategic perspective on the cyclical progress of the overall market, facilitating timely changes in investment strategy, portfolio hedging or asset allocation as conditions fundamentally evolve.

Heatmaps: Visualizing Sector Rotation Dynamics

The Market Navigator Sector Heatmaps are designed to provide an intuitive framework for rapidly assessing and anticipating sector rotation dynamics.

Heatmaps are a top-down market-by-sector analysis tool, where the the 51 second tier sub-sectors under the 10 top levels sectors (see sector structure) are displayed in a unique visual format, providing color-coded and numerical ranking based on proprietary, value-added sector data generated by the MarketScalpel database

Market by Sub-Sector Matrix

The total market is broken down by sub-sectors arranged in an upstream/downstream industry matrix designed to show industry value-added and/or vertical industry integration increasing from left to right and top to bottom. (see analytics/Navigator demo).

Sub-sector segments are sized according to their contribution to the overall parent sector market cap, facilitating rapid assessment of the relative importance of shifts in sub-sector dynamics.

The precise placement of sub-sectors within the total market matrix is to some extent subjective. Experience nevertheless confirms that this arrangement is optimal, typically revealing clusters of emerging sector strength and/or weakness, that spread or contract according to market dynamics. 

However, the layout allows clients to easily evaluate the market along alternative lines such as cyclical/non-cyclical or discretionary/non-discretionary sectors, or to monitor key sectors such as Banks and Retail that typically lead the market (see Do Industries Lead the Stock Market? (Hong, Torous & Valankov).

Identifying Sector Leadership: Key Metrics

Various key ranking criteria are selectable for the sub-sector matrix via the Display Option drop-down box in the Market Navigator control panel (see B in the controls overview):

• Returns:

    1-day, 1-week and 1-month returns (also adjusted for the sector beta by toggling the button above the sector matrix). 1-month returns are the best predictors of sustainable sector momentum but shorter time frames allow emerging trends in sector leadership to be identified early 

• Volume Confirmation:

    Proprietary statistical measure designed to pinpoint exceptional buying and selling activity. Raw 1- and 2-day signals are shown as well as the normalized ranking based on the 1-week and 1-month exponential moving average of 2-day signals. The volume confirmation ranking evaluates sector price changes against the corresponding money-flow and breadth, and as such provides a valuable adjunct to a purely return based ranking by filtering out noise not backed up by significant buying or selling.  A radio button above the matrix toggles the display between current and the 1-week change in ranking to identify where momentum is building

• Components above Key Moving Averages:

  The percentage of sector components trading above the 10, 25, 50 and 200 day moving average of their respective share prices. These are key overbought/oversold measures used to identify momentum and contrarian opportunities

• Relative Volume:

  1-day, 1-week and 1-month volume relative to the 1-year sector average. Adjunct to the Volume Conformation rankings showing where volume is concentrated.

• 52-Week Highs less Lows:

   Alternative method of visualizing momentum and identifying contrarian opportunity

• Cycle Metrics:

  : Visually presents estimates for dominant short and long tern sector cyclicality based on our Spectral Analysis algorithm and proprietary post-processing logic

Determining Sector Allocation

Fast 1-click switching between the Sector Heatmaps' visual sector ranking options, provides a highly intuitive framework for rapidly identifying upside and downside sector leadership, and gaining a strategic overview of sector rotation.

With experience the development of sector rotation patterns can be anticipated, allowing clients to tailor tactical sector allocation to enhance returns through early identification of sector leadership.