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Beat the Market With Sector Rotation

Updated July 2012

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-annualy performing sectors monthly.

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 46.8% versus 15.1% 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 0.19 compared to SPY’s 0.07.

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 the last 12-month price performance for the nine SPDRs, 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 Jun-12 Return Excess Return over S&P
Staples XLP 14.53% 11.38%
Utilities XLU 13.92% 10.78%
Technology XLK 13.51% 10.37%
Discretionary XLY 10.61% 7.47%
Healthcare XLV 9.29% 6.14%
Industrials XLI -2.11% -5.26%
Financials XLF -2.85% -6.00%
Materials XLB -8.41% -11.55%
Energy XLE -10.42% -13.56%
SPY 5.32% 2.18%
S&P 3.14% 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 XLP, XLU and XLK 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 Juny 2012, the hypothetical ABM portfolio returned 46.8% and the benchmark SPY, 15.1%. The volatility was identical. But of course, the risk-adjusted ratio of the ABM portfolio was more than double that of the benchmark.

12/1999   to 6/2012 “ABM” SPY
Total Return 46.8% 15.1%
Annualized Return 3.1% 1.1%
Volatility 16.2% 16.2%
Risk Adjusted Return 0.19 0.07