Breaking Down Sector Allocation | ETF Profits
Breaking Down Sector Allocation
At the beginning of last month, I wrote about a potential short-term rally that could be in the making — this was before the S&P 500 lost 7.2% for the month of September. At that time, the worst performing sector ETFs, as measured by their excess return over the S&P 500 ETF (SPY), were Materials Select Sector SPDR (XLB), Financial Select Sector SPDR (XLF) and Industrial Select Sector SPDR (XLI).
These sectors were not trading on their fundamentals, as they were trading based on fear. Fast forward to today: The S&P 500 is booming with a positive return of 6.7% for the month, virtually erasing last month loss. Some attribute it to the favorable unemployment report, some to oversold market, some to potential resolution of the Greek default crisis and some to favorable earnings season.
I believe that the investors are looking for any signs of relief they can find from the doom and gloom of the past several months. And who can blame them? We had seen five straight negative months since May (-1.35%, -1.83%, -2.15%, -5.68%, -7.18%) with a cumulative negative sum of -18.18% returns.
So is the current rally going to last? That is the big question. Here are my thoughts and how to approach asset allocation for the near term.
The best way to approach our investment portfolios and allocations today is to take a look at the best performing sectors for the month, which are Materials (XLB), Energy (XLE), Consumer Discretionary (Consumer Discretionary Select Sector SPDR (XLY)), Industrials (XLI), Financials (XLF) and Technology (Technology Select Sector SPDR (XLK)), as measured by their relative outperformance to the SPY. The worst performing sectors are Utilities (Utilities Select Sector SPDR (XLU), Health Care (Health Care Select Sector SPDR (XLV)) and Consumer Staples (Consumer Staples Select Sector SPDR (XLP)) as measured by their relative underperformance to the SPY.
What is happening here is pure and unadulterated jubilation: The defensive sectors are dumped and the previously unloved sectors are in, irrespective of their intrinsic value. Due to such a long down market over the previous months and certain market expectations mentioned above (which have not been realized yet), it is most likely that the rally will continue in near term over several weeks, while we wait for news from different fronts.
As of today, XLB, XLF, XLI and XLY are all very close to achieving their historical monthly Excess Return. Based on our analysis, these sectors have another 5%-10% additional probability of higher returns. While XLE and XLK still have much room to grow, based on our analysis, they have 30%-50% additional probability of higher returns.
So the answer to the question of where should you allocate today, as always, depends on your risk tolerance, your time horizon and your perception of the future. If you are willing to take on more risk and continue to ride the fast train over the next several weeks, then consider XLB, XLF, XLI and XLY — some portion of your high-risk allocation should go to these sectors. If you are more risk averse, you might want consider allocating a portion of your portfolio to XLE and XLK.
At the time of publication, Rockledge clients had long positions in XLB, XLE, XLF and short positions in SPY, XLP, XLU, XLV, XLY.