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Sector Rotation Trading Strategy (ChartSchool)

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Sricharan Sairi
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177 views

Sector Rotation Trading Strategy (ChartSchool)

Uploaded by

Sricharan Sairi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Faber's Sector Rotation Trading Strategy

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Sector Rotation-based trading strategies are popular because they can improve risk-adjusted
returns and automate the investing process. Momentum investing, which is at the heart of
the sector rotation strategy, seeks to invest in sectors showing the strongest performance
over a specific timeframe. Momentum investing is another form of relative strength
investing. This article will explain the strategy and show investors how to implement it using
the tools at StockCharts.com.

Faber and O'Shaunessey


There are many papers supporting the concept of momentum investing and relative strength
investing. In his book, What Works on Wall Street, James O'Shaunessey details the best
performing strategies over the last fifty years. Now in its fourth edition, O'Shaunessey found
that relative strength strategies were consistently at the top of the performance list. Investors
are rewarded for buying the strongest stocks and avoiding the weakest. The strong tend to
get stronger, while the weak tend to get weaker. This makes sense because Wall Street loves
its winners and hates its losers.
Mebane Faber, of Cambria Investment Management, wrote a white paper entitled Relative
Strength Strategies for Investing. Using sector/industry group data going back to the 1920s,
Faber found that a simple momentum strategy outperformed buy-and-hold approximately
70% of the time. In other words, buying the sector/industry groups with the largest gains
outperformed buy-and-hold over a test period that exceeded 80 years. This strategy worked
for 1-month, 3-month, 6-month, 9-month and 12-month performance intervals. Furthermore,
Faber also found that performance could be improved by adding a simple trend-following
requirement before considering positions.

Strategy Details
The strategy described here is based on the findings in Faber's white paper. First, the strategy
is based on monthly data and the portfolio is rebalanced once per month. Chartists can use
the last day of the month, the first day of the month or a set date every month. The strategy is
long when the S&P 500 is above its 10-month simple moving average and out of the market
when the S&P 500 is below its 10-month SMA. This basic timing technique ensures that
investors are out of the market during extended downtrends and in the market during
extended uptrends. Such a strategy would have avoided the 2001-2002 bear market and the
gut-wrenching decline in 2008.

In his backtest, Faber used the 10 sector/industry groups from the French-Fama CRSP Data
Library. These include Consumer Non-Durables, Consumer Durables, Manufacturing, Energy,
Technology, Telecommunications, Shops, Health, Utilities and Other. “Other” includes Mines,
Construction, Transportation, Hotels, Business Services, Entertainment, and Finance. Instead
of searching for individual ETFs to match these groups, this strategy will simply use the nine
sector SPDRs.
The next step is to choose the performance interval. Chartists can choose anything from one
to twelve months. One month may be a little short and cause excessive rebalancing. Twelve
months may be a bit long and miss too much of the move. As a compromise, this example
will use three months and define performance with the three-month Rate-of-Change, which
is the percentage gain over a three-month period.

Chartists must then decide how much capital to allocate to each sector and to the strategy as
a whole. Chartists could buy the top three sectors and allocate equal amounts to all three
(33%). Alternatively, investors could implement a weighted strategy by investing the most in
the top sector and lower amounts in the subsequent sectors.

Buy Signal: When the S&P 500 is above its 10-month simple moving average, buy the sectors
with the biggest gains over a three-month timeframe.

Sell Signal: Exit all positions when the S&P 500 moves below its 10-month simple moving
average on a monthly closing basis.
Rebalance: Once per month, sell sectors that fall out of the top tier (three) and buy the
sectors that move into the top tier (three).

StockCharts Sector Summary

The Sector Summary at StockCharts.com can be used to implement this strategy on a


monthly basis. The nine sector SPDRs are shown on one convenient page with an option to
sort by percentage change. First, select the desired performance timeframe by using the
dropdown menu just above the table. This example uses three-month performance. Second,
click the “% Chg” heading to sort by percentage change. This will place the best performing
sectors at the top.
Tweaking
At the risk of curve-fitting, it seems that a 12-month simple moving average holds a strong
trend better than a 10-month SMA. On the chart below, the blue arrows show where the S&P
500 broke the 10-month SMA, but held the 12-month SMA. The difference between the two
moving averages is quite small and these differences are likely to even out over time. A 12-
month moving average, however, does represent the one year average, which is an
appealing timeframe from a long-term standpoint. Price has an upward bias when above this
one-year moving average and a downward bias when below.

Conclusion
This sector rotation strategy is built on the premise that certain sectors will outperform and
investing in these sectors will outperform the market overall. Even though an 80+ year
backtest confirms this assumption, past performance is no guarantee of future performance.
As with any strategy, self-discipline and adherence to the strategy are paramount. There will
be bad months, perhaps even bad years. However, long-term evidence suggests that the good
times will outweigh the bad times. This strategy can also be used as a first cut for stock
selection. Traders can focus their efforts on stocks in the top three sectors and avoid stocks in
the bottom six. Keep in mind that this article is designed as a starting point for trading
strategy development. Use these ideas to augment your analysis process and risk-reward
preferences.

Further Study
Technical Analysis of
the Financial Markets
John J. Murphy

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