A strategy of buying the winning sectors, to beat the market index
For decades, US stock markets have provided a template of how to make money from stocks: you simply buy and hold stocks of large companies, for the long term. Then came the decade of 2000 when the faith in ‘buy & hold’ was shaken. The S&P500, a popular index of 500 stocks, hit a high of 1,553 in March 2000 and crashed to 768 in December 2001.
Then, it soared to 1,576 in December 2007 and crashed to 675 in March 2009. By the end of the decade, it was at 1,115, a 30% decline from the 2000 peak. The index had hit 1,110 for the first time in March 1998. This means that the index delivered no gains over 13 years. The mantra of buy & hold shares yielded little—even assuming that you could keep the faith in the mantra during the two gut-wrenching 50%+ declines, in the interim.
This has sent a lot of serious people back to their drawing boards. If buy & hold was not the right strategy, what was? The new mantra is sector rotation using exchange-traded funds which are exceptionally low-cost compared to mutual funds. They also remove the bias of stock selection. You only need to move in and out of sectors that are strong.
The theory is as follows. During various points in the economic cycle, one can expect certain sectors to lag and others to outperform. There are nine major constituents of the S&P500: consumer discretionary, consumer staples, energy financials, healthcare, industrials, materials, technology and utilities. More cyclical sectors, like consumer discretionary, materials, industrials and energy, can be expected to lead during expansionary cycles, whereas, during a contraction, more defensive sectors, such as healthcare, consumes staples and utilities, will rotate into positions of leadership.
If so, it only makes sense for an investor to participate in those sectors’ positive price momentum and to avoid those which are under pressure; in doing so, they could achieve market-beating returns. As the author Matthew P Erickson argues, “While the performance of the S&P500 as a whole often serves as a benchmark for stock market performance, the sectors that make up this index often have returns that are very dissimilar from it, and often very different from each other.”
For instance, in 1999, the technology sector was hot. While the S&P500 was up 21% that year, the technology sector was up over 65%. In 2000, when the tech bubble burst, the sector lost over 42%, while the S&P500 was down only 10%. Now, here is the shocker. In that year too, four sectors were up by 20%! Interestingly, these were the four worst-performing sectors in 1999. In 2001, losses in the US stock market were humongous. The S&P500 was down almost 12% and the tech sector was down another 23%; yet, there were two sectors with positive returns. The aim of this book is to make you aware of this approach—look for the winning sectors.
Add In Fixed Income
In years like 2000 and 2008, when all equity sectors are experiencing prolonged declines, there has always been a flight to safety: the US Treasury Bond. Whenever the stock market has experienced negative returns, the US Treasury Bond has always held up and, in most cases, actually achieved positive rates of return. For this reason, this asset class must be present in any asset rotation-based portfolio.
How to construct an asset-rotation portfolio? Start with two types of assets: risk assets and those that will provide safety. “The correlation between these two types of assets should be low, so that there is a greater chance that one is doing well when the other is not.” Ideally, there should be a negative correlation.
It is also important that there are multiple risks assets within the eligibility list and these eligible securities should also possess a relatively low correlation to each other. The process would be to simply pick from what was up the most during the previous month. When less than five of the nine sectors of the market have a positive rate of return, the portfolio will rotate incrementally into fixed income.
This is an interesting and a logical approach. However, it would take some time to implement in this country because we hardly have any sector ETFs.