Can A Sector Rotation Strategy Beat The Market?

sector rotation 3 wk
  • We look at how sectors move, relative to the market and to each other.
  • The return behavior of sectors over time offers investors valuable information.
  • This relative return behavior gives us clues about shifting market leadership.
  • How you allocate equity exposure among sectors is a key driver of portfolio performance.

 Introduction

A popular approach among active investors is a sector rotation strategy. To oversimplify, this strategy involves taking advantage of the fact that different market sectors behave differently, depending on where we are in the economic cycle. For this article, I looked at the historical returns of the ten sectors of the S&P 500 since 1999 – the first year for which we have complete data on all the sector ETFs.

I begin with a table that summarizes the returns of these sector ETFs over each of the time frames I included in the study. I then created 7 charts that show the ranked performance of each sector ETF over each of the 7 time frames in the study.

Lastly, I created 4 charts on specific sector ETFs that represent the strongest and weakest relative performance over the full 17-year period. These charts offer clues about how these 4 sectors evolved over time.

Table 1 Total % returns of all sector ETFs for each time period.

sector table 06-17

 

 

 

 

 

Some observations based on the table above

The Consumer Discretionary sector is the best relative performer since January 1999. This is a little surprising, since the period studied included two recessions and two severe bear markets.

Discretionary stocks took a serious beating during the two recessions, but when the market bottomed in 2009 they took off like a rocket and never looked back.

Health Care came in second, which isn’t surprising. The rapid rise in health care costs has been a windfall for the companies that sell medical products and services to consumers.

Energy comes in at #4. The only thing that’s a little surprising about that is the beating energy has taken recently. On a long time frame, that recent beating amounts to a partial give-back of a strong sector.

The big laggard is Financials. Not surprising, given the financial meltdown in 2008. The damage done during that crisis was serious enough to cripple the long-term performance of this sector.

Lastly, I find it interesting that 8 out of 10 sectors beat the S&P 500 over the full 17-year period. I’m not sure what to make of this, but maybe it is further evidence of just how badly Financials have performed. It’s a big sector, so it carries a lot of weight in the S&P index.

 

Sector returns for each of the time periods studied

Following is a series of seven charts; one for each of the seven time periods. (For brevity, I skipped the 3 year period. You can find the numbers in the main table above.) Each table is arranged in order of best to worst return performance. The performance of the S&P 500 is highlighted in gold for clarity.

 

Chart 1  Total % returns of each sector over the full 17 years

I look at this chart as a long-term baseline of which sectors have established lasting leadership throughout a period that included two recessions and two bear markets. The relative rankings on this chart don’t change very quickly, which makes it appeal to very long term, buy and hold investors.

However, as a tool for making allocation decisions in the present, it has little value in my opinion.

 sector rotation 17yrs

 

 

 

 

 

 

Chart 2  Total % returns of each sector over the past 10 years

When we shorten the time frame from 17 to 10 years, some new information comes to light. For one thing, this chart begins in June 2007 – just before the financial meltdown and severe bear market of 2008. It also eliminates the earlier crash of 2000-2002.

 

 

 

 

 

 

 

Notable to me is that Health Care maintains its leadership role, which shows how resilient this sector is in our economy. Same thing with Discretionary.

Financials are the unsurprising losers during this time frame. But Energy has lost its mojo, flipping from leader to laggard. Although I haven’t considered it yet, I would wager that the falling fortunes of the Energy sector is directly related to the price of crude oil. 

Chart 3  Total % returns of each sector over the past 5 years

As we continue to narrow the time frame, the information value contained in these charts begins to increase. Health Care is still on top, which is no surprise. When you’re sick or injured, you spend what’s necessary to get help. When you’re low on gas, you might adjust your consumption patterns.

 

 

 

 

 

 

 

Notice the sharp rebound in Financials. It looks to me like 2012 was the end of the most painful chapter in this sector, excluding of course the crash of 1929 which saw massive bank failures. Energy continues to bring up the rear in the sector parade.

Chart 4  Total % returns of each sector over the past 2 years

Now we come to the 2-year time frame, which contains all manner of valuable information. The first thing I noticed was the extreme outperformance of Utilities and Technology. What’s interesting about this is that these two sectors are being driven by very different dynamics.

 

 

 

 

 

 

 

Utilities are driven by investors’ search for yield, and that’s a conservative strategy. Technology, on the other hand, is driven not by yield-seekers, but by growth-seekers. This time frame includes the early stages of the FAANG revolution. (Facebook, Apple, Amazon, Netflix, and Google.)

You couldn’t have two classes of investors more different than these. Now add to the mix the 2016 presidential race, and you get a recipe for major shifts in sector performance. (Sorry, Energy. You’ll have to sit this one out.) 

Chart 5  Total % returns of each sector over the past 1 year

The one year picture offers a treasure trove of information about what’s going on under the surface of the headline number of the S&P 500. For example, you’ll notice that Financials, which have been staging a comeback since 2012, have now taken over the #1 spot on the sector leader board. Why is that?

Among other things, the Fed is telling the world that zero interest rates are over. As rates move (ever so slowly) higher, the spread banks make on their loans increases, and so do their profits. Another factor is deregulation. Trump and the republican congress have pledged to roll back Dodd-Frank, and eliminate red tape that restricts the activities and capital requirements for banks.

sector rotation 1yr

 

 

 

 

 

 

 

This new leadership looks sustainable, at least to me. But alas, poor Energy continues to bring up the rear. There’s an oversupply of oil these days. Fracking in the U.S. is adding to oil and natural gas supplies. And the melting of the polar ice cap is opening new opportunities for Russia and the U.S. to drill baby drill in Alaska and the Arctic Circle.

Chart 6  Total % returns of each sector over the past 3 months

This is where things start to get interesting for sector rotation buffs. Three months is a very short time frame, but it is also, in my view, a long enough time frame to carry some important information. The trends can change quickly, of course, but they can also telegraph changes in appetites on the part of big money, smart money, and fast money.

 

 

 

 

 

 

 

The dominance of Health Care remains unchallenged. Technology continues to outperform, despite recent setbacks. But look at Financials. They have slipped, and now are barely staying ahead of the market. What are we to make of this? It is an indication that the trend in Financial leadership is fading? Or is it just a normal correction for a sector that got a little ahead of itself?

These are the kinds of questions that sector rotation buffs are constantly asking themselves.

Chart 7  Total % returns of each sector over the past 3 weeks

We have finally arrived at our most narrow window into the behavior of market sectors. On this very short-term basis, Health Care and Financials are leading the market. Health Care is no surprise, since they have established themselves as durable, long term leaders.

 

 

 

 

 

 

 

But Financials were struggling a little on the 3-month chart. Does this 3-week rebound mean that Financials simply went through a normal correction? Are they back in leadership mode? Ultimately, it’s up to you to make that call.

Technology, Telecom, and Staples continue to struggle. These trends can reverse quickly, and they often do. In my view, the value of this chart lies in its potential to give early signs of shifting leadership. I think of it as “The Chart of What’s Happening Now.”

 

Putting some context into sector rotation

The last four charts will focus on the big picture. Starting with the S&P 500 as our benchmark, we look at how the market itself, and the leading & lagging sectors, have performed over the entire 17 years in this study.

 

Chart 8  S&P 500 price history since June 1999

 

 

 

 

 

 

 

 

 

We can see that from January 1999 to today, the market has basically doubled in price. Is that a good return? No, not by a long shot. A double over 17 years translates into a compound annual return of barely 4.2%. It’s easy to understand why this is the outcome, with two recessions and two nasty bears and all.

But note the trajectory of this charging bull market since the March 2009 low. The market went from 700 to 2,440. That’s more than a triple in just 8 years. That’s a compound annual growth rate of 17%. That’s pretty good, wouldn’t you say?

 

Chart 9  Consumer Discretionary sector price history since June 1999

 

 

 

 

 

 

 

 

 

Consumer Discretionary is our best performing sector over the entire 17-year period. While the S&P 500 doubled, this sector quadrupled. That works out to a compound annual return of 19%, compared to the market return over the same period of just 4.2%.

(The next time someone tells you that the way you allocate your equity investments among sectors doesn’t make much difference, send them this article.)

 

Chart 10 Technology sector price history since June 1999

The Technology sector essentially matched the market return over the 17-year period. So why am I showing you this chart? Because Technology is such an interesting sector.

Technology influences every aspect of our economy. It’s the engine of innovation and productivity. It’s also one of the few remaining competitive advantages the U.S. has, compared to the rest of the world.

 

 

 

 

 

 

 

 

 

This chart shows the wide range of prices for Technology. We can see the Tech bubble in 2000, then the crash from 2000 to 2002, the attempted recovery that was wiped out during the 2008 market meltdown, and the great recovery since then. Unfortunately, Technology has only returned to its former high water mark that dates back to the Tech bubble of 2000.

If we measure the progress of Technology over the full 17 years, we see that it barely outperformed the S&P 500. If we measure it from the peak in 2000, it only recently surpassed that old high.

In my view, the history of the Technology sector represents a cautionary tale for investors. On one hand, it’s an extremely important part of our economy, and our future. But on the other hand, it’s volatile. No other sector has such an extreme range of prices over the long term. I would rather not over-allocate to Technology when it’s at or near the top end of its historical price range. But I would do so if it pulled back to its long-term mean. But that’s just my opinion. You should make your own decision.

 

Chart 11 Financial sector price history since June 1999

Despite their recent revival, Financials have the dubious honor of being in last place among the ten sectors over the full 17 years. This chart shows why. The financial meltdown of 2008 devastated this sector, and it hasn’t yet fully recovered to its previous high water mark.

 

 

 

 

 

 

 

 

 

Looking at the entire history, Financials have gained 65% over the past 17 years. That works out to an annual return of 1.3%. Although Financials have come roaring back since 2009, they have yet to surpass their 2007 highs.

 

Final thoughts

There is a large and growing school of thought that asserts the only correct way to invest is by owning the entire market- all ten sectors (eleven now that REITs are included). I have no argument with that approach for most investors who lack the time or interest in the investing process.

But remember what today’s study told us. The market return over the last 17 years was only 4.2%. If you are looking for a simple, low-maintenance investment strategy, then 4.2% is what you should reasonably expect.

But if you have the time, and the interest to try to do better than that, sector rotation is one of several ways to capture alpha (excess return above the market return). Factor-based stock selection is another way. Market timing based on avoiding economic recessions is another way.

The advocates of buy-and-hold, indexed investing (who now describe this approach as “Evidence-Based Investing”) tend to look down on the alpha-seeking crowd. But this is unjustified, in my view. After all, we’re talking about your money.

Does anyone have the moral authority to declare which approaches to investment decision-making are good, and which are bad? I don’t think so. There are clearly some approaches that are nothing more than scams, bereft of any objective value. But to claim that passive indexing is the only legitimate way for every investor to manage their money is, to me, the height of arrogance.

About the Author

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

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