Watering the flowers and pulling the weeds. Letting your winners run and cutting your losers short. There are different expressions for sector rotation, but it is among the most profitable investment strategies we have found, when done in a disciplined way. Sector rotation is based on the idea that there tends to be differences—sometimes large differences—in performance between various sectors of the market. For example, so far this year Healthcare has been among the best performing sectors and Utilities has been among the worst. One application of relative strength is to rank the broad macro sectors (Healthcare, Utilities, Energy, Consumer Cylclicals…), buy the top ranked sectors and avoid the weakest. However, there are different ways to classify stocks in a sector. Sub-industry groups (Distiller & Vintners, Technology Hardware, Airlines, Household Appliances…) can be evaluated to get a more granular look at strength and weakness in the market. The next logical question is which sector classification should be used. The answer will depend upon your objectives, because there are trade offs. Consider the following excerpt from John Lewis’ 2014 white paper Sector Rotation with Point and Figure Matrices.
Macro sectors are blunt tools for sector rotation. Investors can purchase targeted funds providing more granular exposure within each macro sector. We ran similar tests on the GICS Sub Industry indexes to illustrate the power of getting more granular with a sector rotation strategy. Figure 4 shows the summary results of testing rotation strategies using the 130 sub industry groups. (Please see Tables 6-10 for more detailed performance.) As with the macro sectors, we ran point and figure matrices at multiple box sizes. Each month the universe of sub industry groups is broken into quintiles based upon their scores in the point and figure matrix. Groups in the 80-100 quintile have the highest scores, and are the groups with the best momentum characteristics.
John’s white paper included a test of two approaches to sector rotation. The first strategy involved trading the 10 broad macro sectors and the second strategy involved trading the 130 sub-industry groups. Both tests were done over the period Dec 1995 – Jun 2014. In the table below, we see the cumulative return for a sector rotation strategy that involved buying 1-5 of the top ranked sectors, using various box sizes in a PnF relative strength matrix. The red-shaded boxes signify the worst performing model and the green-shaded boxes signify the best performing model.
Key takeaways from macro sector model:
- Using a very sensitive relative strength box size (1%) typically led to the worst returns, while using a box size of 3-4% tended to work much better.
- The fewer sectors held the better the performance was over time. However, this will also likely be accompanied with greater volatility
- A sector rotation strategy that trades the broad macro sectors has shown the ability to outperform the S&P 500 over time
In the table below, we see the cumulative return for a sector rotation strategy that involved buying quintiles of the sub-industry groups, using various box sizes in a PnF relative strength matrix. For example, a sector rotation strategy that buys the top quintile (80-100 rank) of the sub-industry groups will hold approximately 26 (130 divided by 5) sub-industry groups. As with the previous model, evaluations and necessary rebalances were done on a monthly basis.
Key takeaways from sub-industry group model:
- Again, using a very sensitive relative strength box size (1%) typically led to the worst returns, while using a box size of about 6% tended to work much better.
- The model focused on buying the top quintile of the sub-industry groups performed significantly better than the other groups.
- A sector rotation strategy that trades the sub-industry groups has shown the ability to outperform the S&P 500 over time
- A comparison of the cumulative returns generated from the macro sector model vs. the sub-industry group model makes it clear that there is significantly more return potential from the sub-industry group model
For a more complete description of the testing completed for this study, please read Sector Rotation with Point and Figure Matrices. We believe that a careful study of this white paper will lead an investor to understand best practices as it relates to implementing sector rotation strategies using a Point and Figure relative strength matrix.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.