How Sustainable is the Recent Sector Rotation?

One of our guiding philosophies when it comes to investing is to focus on leading stocks in leading areas of the market. But how do we know which areas of the market are leading and how can we be confident that they will continue to lead? The answer to the first question is pretty simple, we can look at performance over a given time frame. The answer to the second question is not as straightforward. The simple answer is, we don’t know if a leading sector or industry group is likely to continue to lead. However, we can use the tools at our disposal to get a sense of how likely it is that leadership will be maintained. 

Let’s start with the first question. What sectors of the market are currently leading? We will use six-month performance to quickly see which sector ETFs have performed the best over that time period and have also performed better than the S&P 500 (using SPY to represent the index). 

A quick glance at the table below shows us that Technology (XLK), Materials (XLB), Financials (XLF) and Industrials (XLI) are all performing better than the market (SPY) over the last six months. With the exception of XLK, the other leaders are relatively new as rotation has been a theme for the past two months.

We could also look at the charts of the individual funds in Chaikin Analytics and see if the fund is leading the SPY or lagging. This indicator provides a consistently scaled indication of a fund’s recent performance relative to the S&P 500. When the gradient gets to green, this indicates the fund has been strongly outperforming the market. In this case we are using XLK as an example of a fund that has been leading the SPY. 

So it is fairly simple to see which sectors are currently outperforming the market. That brings us to the more difficult question of how likely is that outperformance to continue. As I stated above, there is no way to know for sure that today’s leading groups will continue to lead tomorrow let alone next week or next month. So it comes down to probabilities. 

The theory of momentum in the stock market has been well documented, most famously in this paper from Narasimhan Jegadeesh and Sheridan Titman. At a high level, the takeaway is that securities that have performed well over the past three to twelve months tend to continue to perform well. If you believe the academic research, which I do, it stands to reason that these outperforming sectors of the market should continue to outperform for the next three to six months.   

But is there another way to assess how likely the current leaders are to continue leading? Our Power Gauge ETF Rating is another tool that investors can use to answer this question. Looking back at the table above, we can see that all of the current leaders have ratings of Very Bullish or Bullish. The rating is comprised of a technical rank of the fund itself and by looking at the proportion of bullish to bearish stocks which are holdings of the fund based on our 20-factor model for rating the stocks. Again, using XLK as an example, we can see that based on the current holdings in the fund, 22 of them are rated Very Bullish or Bullish and only 6 are rated Very Bearish or Bearish. In fact, all but XLB have more bullish stocks than bearish stocks in their holdings.

Does this mean that outperformance is guaranteed to continue? Of course not, nothing is guaranteed in the market. However, odds favor this being the case. 

Now What?

Investors who are focused on using ETFs to construct portfolios that go beyond market index funds can begin to look at the leading sector ETFs with Very Bullish or Bullish ratings for possible addition to portfolios. I realize that there is more to this decision but I am speaking broadly here.

Investors who wish to identify individual stocks that are likely to outperform the market over the next three to six months can run a screen using these market leading sectors as a starting universe. From there they can identify the stocks that have Very Bullish or Bullish ratings in our model that are outperforming the market and also have bullish Chaikin Money Flow (a sign of accumulation on the part of investors).

That screen returns 40 names (from a starting universe of 231) that can now be added to a watchlist for consideration when they are oversold.

The fact is, we can’t know for sure if these groups are going to continue to outperform but we can greatly increase the odds of success by applying a disciplined process and using the right tools for the job.  

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