What is sector rotation, and how can I use it in my trading?
The theory behind sector rotation asserts that certain sectors of the economy (technology, financials, utilities, etc.) are more profitable in specific stages of the business cycle, and that as a result, we can expect those sectors or the individual stocks within them to outperform the broader market. Individuals or institutions who decide to adopt this investment strategy would continuously rotate their money into these strong sectors as the economy shifts from one stage to another.
Under the EduTrader’s™ tools menu you can access a sector rotation model based on Sam Stovall’s S&P’s Guide to Sector Rotation. The model divides the market cycle into four stages: market bottom, bull market, market top, and bear market. In addition, it also displays the stages of the economic cycle: full recession, early recovery, full recovery, and early recession. By determining the current stage of each cycle, you can ascertain which sectors should currently outperform the market, as well as anticipate those sectors that should outperform in the near future. Keep in mind the model is theoretical and merely serves as a simplification of the real world. In reality, there are numerous variables that affect these sectors, often causing discrepancies between what the sector rotation model says should be happening and what actually is happening.
Rather than getting too caught up in the theory behind sector rotation, the easiest method for tracking the sectors that are doing well is via the charts. Remember, charts are the footprints of money; consequently, if we wanted to assess which sectors are outperforming the broad market, we merely need to assess their respective charts. We can see institutional money flow by assessing which sector charts look bullish or bearish. If a specific sector chart is in a strong uptrend, it’s a good bet institutions are putting money into or accumulating stocks in that sector. Conversely, if the sector chart is in a strong downtrend, institutions are probably taking money out of that sector. Although there are a few different ETFs or indices that can be used to track each sector, we’re going to use the Select Sector SPDRS, which can be found on www.sectorspdr.com. With EduTrader, you can actually import them right into your quote sheet. To import, right click on your quote sheet and then find “import symbols” in the drop down menu. Within the import symbol lists, you should find one that says “sector spiders.” This will import the following nine ticker symbols: XLE, XLY, XLU, XLI, XLP, XLF, XLK, XLV, and XLB. Each represents one of the following nine major sectors: energy, consumer discretionary, utilities, industrials, consumer staples, financials, technologies, health care, and basic materials.
Once you’ve identified a sector you feel will outperform the market, you have two choices: trade the sector ETF, or trade an individual company within the sector. Utilizing sector ETFs is more conservative due to the diversification they provide. Because the ETF is a basket of stocks, it doesn’t tend to move in a manner as volatile as that of individual stocks. If you don’t want to take this more conservative route, you could drill down into the sector to find individual stocks you think are poised to outperform the market. Within the import symbol lists in the EduTrader, you can also import a list of major stocks in each of the nine sectors by finding the sector ETF symbol (XLE, XLY, XLU, etc.).
Once you’ve familiarized yourself with sector rotation, it will serve as one more method for finding trade candidates, in addition to the TradeSeeker.