Does Sector Rotation Work?
Sector rotation is one strategy among many that investors have at their disposal. Does sector rotation work better than the others? The quick answer is probably not. Only the most experienced and knowledgeable investors have what it takes to perfectly predict the cycles of every sector. It takes much more effort and risk to come up with a perfect strategy. Today, we will look at sector rotation and other similar strategies for investors.
What Is Sector Rotation
On paper, sector rotation seems easy. Most sectors follow a cycle.
- Market bottom or accumulation phase: The lowest point of stocks during a cycle. This is when market sentiment begins to switch. Investors accumulate shares of companies that seem poised for a bull run.
- Bull market or mark-up phase: The markets are calm and stocks steadily rise. Market sentiment is finally positive. More and more investors pour their funds into the stock market.
- Market top or distribution phase: The bull run finally slows down. Investors begin to sell. Indicators are sending mixed signals. We reach the maximum share price for the stocks in a sector.
- Bear market or mark-down phase: Stock prices finally go down. It is the precursor to the market bottom or accumulation phase.
Does sector rotation work? The goal of sector rotation is to invest in a sector when the market bottom is reached. Investors have the option of picking out the best stocks or investing in an ETF.
Both strategies will give different results. Market leaders can grow much slower than mid-cap stocks. If investors choose to pick individual investments, they must include in their calculations the fees every time they buy and sell stocks.
This can be an issue with smaller accounts or with more expensive brokers. Once the sector hits its peak, it becomes time to sell and move the funds to a different sector. The timing can be very tricky and extremely hard to predict. It seems easy on paper, but difficult in real life.
According to the Global Industry Classification Standard, there are 11 sectors to choose from.
- Financials (Financial institutions, banks, insurance companies)
- Real Estate (REITs)
- Consumer Discretionary (Nonessential goods and services)
- Technology (Electronics, software, IT, AI, etc)
- Industrials (Machinery, aerospace, defense sector)
- Materials (Chemicals, mining, forestry, discovery, development, and processing of raw materials)
- Consumer Staples (household products, food, beverage)
- Health Care (Pharmaceuticals, biotech, pharma)
- Energy (Oil, renewables)
- Communication Services (internet, phone, streaming services)
- Utilities (Energy services, electricity, gas, water)
Does sector rotation work? The first thing to do before investing in the sector is to do a top-down analysis. This means looking at the state of the overall market.
We need to have a good idea of the overall market conditions by taking a look at various economic factors.
Next, we need to pick a sector based on the state of the economy. Cyclical stocks outperform the market when the economy is growing.
They are related to nonessential spending such as entertainment, home repairs, or buying new gadgets. On the other hand, defensive (non-cyclical stocks) stocks have steady demand no matter the state of the economy. They are essential items such as food, healthcare, and utilities.
For the following example, we will take a look at an ETF and at stocks for the tech and energy sectors over two time periods. First, we will look at the tech sector from March 2020 until December 2021.
Next, we will analyze the energy sector from December 2021 until March 2022. We will use the S&P index as a benchmark. It grew almost 108% from March 2020 until December 2021 and is down over 11% since.
March 2020 – December 2021 – Technology Sector
Does sector rotation work? To begin this example, we will pretend an investor put all their funds in the tech sector at the lowest point in March 2020 and sold everything at the highest point in December 2021.
We will begin with two ETFs in the sector with different approaches. We can agree that tech stocks can be considered cyclical since they are not essential to our well-being.
Vanguard Information Tech (NYSEARCA: VGT)
This Vanguard ETF is the biggest in terms of total assets managed in the sector with over $46B. Its top holdings contain every company we can think of in the tech industry such as Apple, Microsoft, NVIDIA, Visa, Mastercard, etc. Between March 2020 and December 2021, it grew over 144%, effectively outperforming the S&P Index. Investors more than doubled their funds in less than 2 years if they timed their investment accordingly.
As the name suggests, this ETF is in a subcategory of the industry. Recently, semiconductors have seen very high demand. There is a shortage and many companies are trying to address it. This subsector becomes an interesting investment, especially for the chosen time period. In fact, it grew over 200% between March 2020 and December 2021. Investors tripled their initial contribution.
Next, let’s take a look at a portfolio consisting entirely of stocks. Did it outperform the S&P or any of the ETFs?
Does Sector Rotation Work With Stocks?
We will pretend an investor invested 10% of their capital into each of the following stocks. The return between March 2020 and December 2021 is next to the stock.
Apple (NASDAQ: AAPL) – 209%
Microsoft (NASDAQ: MSFT) – 144%
Amazon (NASDAQ: AMZN) – 80%
Google (NASDAQ: GOOGL) – 171%
Netflix (NASDAQ: NFLX) – 81%
NVIDIA (NASDAQ: NVDA) – 471%
Broadcom (NASDAQ: AVGO) – 246%
Visa (NYSE: V) – 47%
MasterCard (NYSE: MA) – 70%
Qualcomm (NASDAQ: QCOM) – 200%
This comes to a return of 171% without any fees for buying and selling each stock. This is also an incredible return for a small time period.
December 2021 – March 2022 – Energy Sector
Energy prices have been soaring for the past few months for many reasons. There is a shortage in Europe and there is a war between Russia and Ukraine that is affecting the global supply. Countries are trying to find alternative suppliers, which isn’t easy.
We continue from where we left off. The same investor saw the peak of tech stocks at the end of December and was well-informed about an energy crisis.
The next step was to put the money in this sector, which is primarily defensive. This time, we will take a look at only 1 ETF which represents well the sector. Returns are as of March 14th.
Energy Select Sector SPDR Fund (NYSEARCA: XLE)
This is the largest ETF in the sector with over $37B in funds managed. The top 10 holdings include in the majority of big oil companies. A small part of their business is focused on renewables. Since the price of oil and its derivatives have skyrocketed in the last weeks, investors gained quite a bit in a short period.
Since December 2021, investors gained over 40%. The tensions with Russia and the rise of countries that can supply Europe and other parts of the world will determine if this sector has much juice left.
In the final section, we will take a look at alternatives to sector rotation.
Alternatives to Sector Rotation
Does sector rotation work? There exist many alternatives to investing in a single sector. Other categories such as growth and value stocks, small/mid/large-cap stocks, and multi-sector ETFs can be great options.
For less experienced investors, this will spread the risk across many different categories. This also removes the timing matter. Investors can put their money and it will grow over time. Over a longer timeframe, it might yield better returns.
Invesco’s QQQ Fund (NASDAQ: QQQ) offers investors a great growth fund.
0% return in 1 year, 0.52% dividend yield.
The SPY Index (NYSEARCA: SPY) tracks the top 500 companies in the US.
5.44% return over 1 year, 1.36% dividend yield
iShares S&P Mid-Cap (NYSEARCA: IJH) is a good window to mid-cap stocks.
-5% return over 1 year, 1.32% dividend yield
Finally, Vanguard Value Index Fund (NYSEARCA: VTV) follows strong value stocks for consistent growth and less risk.
7.59% return over 1 year.
Does sector rotation work? Sector rotation can be a good strategy for seasoned investors. It can be risky to put all your funds in a single sector. It takes a calculated approach, but it can be worth it.
Gains can be over 100% if timed correctly. For investors that are looking to spread their risk around, plenty of alternatives to sector rotation exist. Oftentimes, they come will lower gains in a short time period, but higher gains over a longer period. In any case, there isn’t a shortage of investment strategies.
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