Beat the Market With Sector Rotation

Everyone wants to outpace the market, usually defined as the  Standard & Poor’s 500 index. While the stock market never guarantees you a  sure-fire win, there’s a clever approach that has triumphed in the last dozen  years. It involves rotating into the best-performing sectors annually.

Last month, I wrote about this interesting investment strategy, which a pioneer of sector investing, Standard & Poor’s Sam Stovall, calls: “There’s Always a Bull Market Somewhere.”

Although my firm does fundamental analysis of companies and sectors, I like Stovall’s approach. It makes money consistently. I back-tested this strategy to December 1998, when exchange-traded funds covering stock sectors became available. The result: This strategy would have earned you 48.5% versus 18.4% from the SPDR S&P
500 (SPY), the State Street Advisors ETF representing the S&P 500 index. And it did so with similar volatility of 16%, which would have provided a risk adjusted return of 0.20 compared to SPY’s 0.09.

The There’s Always a Bull Market Somewhere portfolio (ABM, for short) is based on the fact that many investors use a tactical asset allocation approach, meaning they change the mix of their assets based on the trailing 12 months’ price performance. The point is that some sectors always are winners, besting others, so you shift your money into the
winners.

The analysis is quite straightforward: You calculate the last 12 months performance of the S&P 500 sectors. They are consumer discretionary, consumer staples, energy, financials, health care, industrials, materials, technology, utilities, as represented by the  corresponding SPDR ETFs (tickers: XLY, XLP, XLE, XLF, XLV, XLI, XLB, XLK and XLU). You rank them and you invest in the top three performers for the last 12 months. You hold your portfolio until the next month, where you repeat the process and invest in the newest top three performers of the past 12 months.

So for example, if you calculate 12-month price performance for the nine SPDRs as of end of April, here is what you would have. Excess return means how much it exceeded – or in the case of a negative showing – trailed the S&P 500.

Sector	Ticker	Return	Excess Return
Discretionary	XLY	14.28%	9.60%
Technology	XLK	13.25%	8.58%
Staples	XLP	11.55%	6.88%
Utilities	XLU	10.99%	6.31%
Healthcare	XLV	8.69%	4.02%
Industrials	XLI	-2.25%	-6.92%
Financials	XLF	-4.16%	-8.84%
Materials	XLB	-8.32%	-13.00%
Energy	XLE	-10.08%	-14.76%
	SPY	4.68%	0.00%

I always add the S&P 500 ETF, or SPY, so as to compare it relative to the index performance and Excess Return.

The top three sectors are XLY, XLK and XLP and this scenario suggests to buy and hold these names till the next month. Then, I recalculate the last 12-month performance for all SPDRs again and rebalance by picking the top three sectors again.

It is simple and elegant, but let’s see if this works. I have recreated this analysis and created a what-if spreadsheet. I run the full analysis with numbers going back to the beginning when these sector ETFs became available, December 1998. That means that I could have only started investing at the end of December 1999, or 12 months
later.

For January 1999 to April 2012, the hypothetical ABM portfolio returned 48.7% and the benchmark SPY, 17.7%. The volatility was identical. But of course, the risk-adjusted ratio of the ABM portfolio was more than double that of the benchmark.

1/2000 to 4/2012	ABM	SPY
Total Return	48.7%	17.7%
Annualized Return	3.3%	1.3%
Volatility	16.2%	16.2%
Risk Adjusted Return	0.20	0.08

The  ABM portfolio performance was already good as of March, but with month-end April numbers, the portfolio added another 0.2 percentage points, while SPY slipped  by 0.7. So far so good, keep using the ABM strategy.

Going  forward, I will update this strategy on a  regular basis and you will be able to see the performance on our website at www.TheRockledgeGroup.com in the  Investment Philosophy category.

 

At the time of  publication, Rockledge clients had long and short positions in SPY, XLB, XLE,  XLF, XLI, XLK, XLP, XLU, XLV and XLY in some portfolios.