CXO Advisory has a very interesting blog piece on this topic. They review an academic paper that looks at the way conventional sector rotation is done. Typically, various industry sectors are categorized as early cycle, late cycle, etc. and then you are supposed to own those sectors at that point in the business cycle. Any number of money management firms (not including us) hang their hat on this type of cycle analysis.
In order to determine the potential of traditional sector rotation, the study assumes that you get to have perfect foresight into the business cycle and then you rotate your holdings with the conventional wisdom of when various industries perform best. A couple of disturbing things crop up, given that this is the best you could possibly do with this system.
1) You can squeak by with about 2.3% annual outperformance if you had a crystal ball. If you are even a month or two early or late on the cycle turns, your performance is statistically indistinguishable from zero.
2) 28 of the 48 industries studied (58.3%) underperformed during the times when they were supposed to perform well. There’s obviously enough noise in the system that a sector that is supposed to be strong or weak during a particular part of the cycle often isn’t.
CXO notes, somewhat ironically:
Note that NBER can take as long as two years after a turning point to designate its date and that one business cycle can be very different from another.
In other words, it’s clear that traditional business cycle analysis is not going to help you. You won’t be able to forecast the cycle turning points accurately and the cycles differ so much that industry performance is not consistent.
Sector rotation using relative strength is a big contrast to this. Relative strength makes no a priori assumptions about which industries are going to be strong or weak at various points in the business cycle. A systematic strategy just buys the strong sectors and avoids the weak ones. Lots of studies show that significant outperformance can be earned using relative strength (momentum) with absolutely no insight into the business cycle at all, including some studies done by CXO Advisory. Tactical asset allocation is finally coming into its own and various ways of implementing are available. Business cycle forecasting does not appear to be a feasible way to do it, but relative strength certainly is!
—-this article originally appeared 3/30/2010. Although the link to CXO Advisory is no longer live, you can get the gist of things from the article. Things don’t always perform in the expected fashion, and paying attention to relative strength can be some protection from the problem. Instead of making assumptions about strong or weak performance, relative strength just adapts.