The art of investing is often the ability to take advantage of the rotations developing in the different sectors in the marketplace. Sector rotations when implemented correctly have proven to add alpha to a portfolio without incurring additional risk. Successful investing in the financial markets often involves the ability of an investor to know the optimal time to shift investment assets from one sector to the next. This may entail deploying cash or by using the proceeds from the sale of securities in one sector to fund the purchase of securities in another sector. This investment strategy is based primarily on the theory that not all sectors perform well at the same time.
The two objectives of sector rotations are: (1) capture excess returns by maintaining positions in the most profitable areas of the market based on the current economic cycle and most important, to be able to anticipate the next market cycle; and (2) diversify positions so that a single or a handful of sectors or a handful of individual stock will not negatively affect the overall returns of a portfolio. The limitations of sector rotation are: (1) it is time consuming to implement as it requires in depth analysis of macro/micro economic analysis as well sector, industry, and individual stock analysis; and (2) moving in and out of sectors can be costly to implement due to trading fees and commissions.
Nonetheless, for the past quarter or so the leading S&P sectors have been heavily concentrated within S&P Technology (XLK), Healthcare (XLV), and Financial (XLF). However, we are detecting a subtle shift in sector leadership, at least from a near-to-medium term perspective. XLK and XLV still reside within the Leading quadrant of the Relative Rotation Graph (RRG) suggesting continued leadership roles. On the other hand, XLF has slipped into the Weakening quadrant suggesting either a correction and/or the start of a near-term underperformance cycle in relationship to S&P peers. In addition, over the past 8-weeks ending in Jan 21, 2020 XLF has returned 2.6% and underperformed SPY (5.9%).
S&P Communication Services (XLC) is a sector that has quietly moved into the Improving quadrant. In fact, XLC has begun to outperform SPY by gaining 8.0% over the past 8-weeks and is now the second-best performing S&P sector after Technology (10.5%). Based on its current progression we would not be surprised to see XLC soon challenge the Leading quadrant possibly as early as the next few weeks.
Although it is still too early to confirm a major trend change in direction of U.S. interest rates, the 10-year US Treasury Yield (TNX) have diverged from the U.S. stock market (SPX). That is, TNX has been declining on the backdrop of rising SPX trend. This divergence, if it persists would warn of near-term uncertainties among investors. The decline in TNX may be hurting the S&P Financials and helping interest rate sensitive S&P sectors such as Utilities (XLU +7.7% over the past 8- weeks) and Real Estate (XLRE +4.6% over the past 8-weeks) and Communication Services from a near-to-medium term basis.