Thursday, July 13, 2017

A New Way to Look at Sector Rotation

Sector rotation has been a staple of tactical asset allocation from the beginning.  Typically, sectors are ranked by momentum over some lookback period (3 months, 6 months, 12 months, etc) and then the top couple are picked and held for a month and then the process is repeated.  On a backtest such a strategy will look pretty good, but lately and going forward there are some issues.

Traditional sector rotation works well when sectors are slow to change leadership.  That way you can latch onto a sector when it is just beginning a move and sell out of a sector when it is just beginning a downturn.  When sectors move quickly and are extremely volatile then traditional sector rotation is a recipe for disaster.  You are getting into a sector when the up move has pretty much reached the top and getting out of a sector when the down move has pretty much reached the bottom.  There are two ways to significantly improve sector rotation going forward, short term mean reversion and using individual stocks.

1. Short term mean reversion---Instead of using an intermediate term momentum approach, which doesn't work in a volatile market environment, you can use short term mean reversion.  This entails buying sectors that are weak and selling those that are strong expecting a snap back.  This approach is perfectly suited to choppy markets as it anticipates that sectors will overshoot to the upside and downside and can capitalize on this.

2. Use individual stocks--Traditional sector rotation involves using sector mutual funds or ETFs.  That works fine in a momentum ranking approach where you will always be fully invested (unless there are not enough positive sectors).  Mean reversion approaches do not lend themselves well to ranking so you will end up not being fully invested most of the time as you are cycling in and out of sectors.  In a strong uptrending market this can lead to under performance.  Individual stocks can be used that have more beta than sector funds or ETFs, that way you can be holding large amounts of cash but still outperform the market in a strong uptrend.

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