SECTOR ROTATION has been a successful investment strategy for decades. It is simply trading those sectors that have performed the best recently. It relies on what the analysts call “persistence,” the ability of a price to continue doing what it was doing before – going up or going down. We can see that in Health Care (XLV) which rallied from 2001 to 2007 and again from 2008 to 2014, and in energy (XLE) which has had spectacular ups and downs and is likely to continue.
Sector rotation is a long-term strategy, normally only reviewed once each month. It looks at the performance of each sector over the past 3 to 12 months, ranks them, and chooses the best 3. It turns out that using 3 or 4 in a portfolio gives the best diversification while still allowing investors to profit from big moves. If you over-diversify, you get an average much like the S&P or DOW.
A Step Farther
We’ve taken it a step farther without changing the basic concept
- Weekly data is used instead of monthly. That makes the program more responsive. It can get out much sooner when a major bear market develops, then reenter sooner when the uptrend resumes.
- A hedge based on the long-term trend of the SPY will cause the program to exit all sectors.
- When the hedge is active, the program is long intermediate and long-term bonds, taking advantage of a market that seeks safety.These three new features make the Sector Rotation program more robust, more stable, and more profitable.
The program chooses from 14 sectors (shown below in alphabetic order), in addition to using the SPY to determine the hedge. It also uses the iShares bond funds, IEF and AGG for hedging.
This is a new program using an old concept. Because of its popularity, and the idea of persistence, we believe the underlying premise is sound. In fact, we use a very similar concept to select candidates, stocks, ETFs, and futures, for our other portfolios. The performance chart below is based entirely on historic testing of this strategy and not actual performance.
You should pay attention to the two sideways periods, the first from 2007 to 2009, when the S&P dropped nearly 50% along with many investors equity. The other during the past year when the stock market seems to be fighting off global depression and exhibiting extreme volatility. During the first sideways period the gains of the two bond funds help keep the returns stable, but interest rates are very low now and profits from bond funds are too small to make a material difference. However, the drawdown would be larger if not for the added returns of bonds.
Over the period from 2003 through the present, this program returned 12.2% per annum with an annualized volatility of 14.1%, giving it an information ratio of 0.86. At the same time, the SPY had an annualized return of 8.0% and a risk of 19.1% for a ratio of 0.42, essentially half the bang for the buck.
We see this performance as realistic because it is not overfitted, and it shows periods of little movement and some drawdowns that are inevitable in all strategies. If you’re looking for something without a drawdown, then consider U.S. Treasuries.
Weekly Order Sheets
Each Saturday subscribers will receive a weekly Order Sheet included with their other Weekly Programs. A sample of an order sheet is shown below for the week ending February 5, 2016. The major index markets were in a downtrend and “hedge” positions are taken in the two bond ETFs. Position size is based on an investment of $100,000 but this can easily be scaled up or down. When the SPY is in an uptrend, each of three ETFs will be allocated 1/3 of the investment. When hedged, as shown below, each of the two interest rate ETFs are allocated ½ of the investment.
A Reminder of the Risk
The period from 2008 until 2014 was a remarkable bull market, all the more interesting because it was unexpected. A great deal of investor money had been out of the market waiting for confirmation that the economy was improving. As of the end of 2013, money is now flowing in. It seems inevitable that the market stalls or declines when the general public joins in. It is artificially pushed up and takes time before the economy can justify the higher price level.
It is rare to find a program that can profit in bull, bear, and sideways markets. We haven’t found one yet. The best we can do is diversify into different strategies so that, hopefully, one or more are making money in the current market. You gain more risk protection using different strategies than you do trading different markets.
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