Sector Rotation Insights and Lessons from 2011

The fact that the S&P 500 “did nothing” in 2011 fails to take into account the performance of the individual sectors of the stock market, some of which returned as much as 15% in 2011.

Let’s review Sector Performance in 2011, learn insights into the Sector Rotation Model, and see where capital flowed during the “lackluster” 2011.

According to the Sector Rotation Model, we divide the market into two major categories:  Offensive Sectors and Defensive Sectors.

Offensive Sectors tend to outperform the S&P 500 during rallies or bullish phases, while the Defensive/Protective Sectors tend to outperform the S&P 500 during declines or bearish phases.

From the two categories, we then break the stock market down into 9 main sectors which are easily reflected above using the AMEX Sector SPDRs.

From the Model, we glean information where to focus our capital or look for individual trading opportunities:

Traders look to buy leading stocks in outperforming sectors during up-phases, short-sell or hedge with weak stocks in weak sectors during down-phases, or otherwise play a combination of the two broader strategies.

So what did 2011 tell us in terms of Sector Performance?

The DEFENSIVE or Protective Sectors outperformed the Offensive Sectors and the S&P 500 in 2011, suggesting investor caution.

All three Defensive Sectors – Health Care, Consumer Staples, and Utilities – roughly tied for best performance of 2011 near a 15% annual gain – that’s compared to the 0% gain of the S&P 500.

In terms of the Offensive Sectors (Consumer Discretionary, Financials, Technology, Industrials and Materials), two beat the S&P (Discretionary and Technology), one tied it (Industrials) and two underperformed it (Financials and Materials).

Again, this is NOT the picture of Stock Market confidence or outright bullishness – if investors are optimistic about the future, you’d expect to see them concentrate their investments (or trading activity) in the OFFENSIVE Sectors instead of the Defensive ones.

Let’s pull the picture back to see the performance of Offensive and Defensive Sectors with the S&P:

What we’re seeing above is the full 2011 Percentage Chart Performance of the Three Defensive (XLP, XLV, XLU) Sector ETFs with the S&P 500 (red).

Take a look at these in terms of rallies and declines in the S&P 500.

Being Defensive, these stocks tend to hold up (fall less) during down-phases yet underperform (rise less) during big bullish moves.

You can also see that these Three Sectors made HIGHER LOWS (did not push to new 2011 lows) during the October S&P 500 bottom – that’s worth referencing.

With the exception of the August sell-off and the November retracement, these sectors maintained a consistent upward pathway throughout 2011, unlike the Stock Market.

Again, this suggests investor caution, hedging, or otherwise lackluster enthusiasm for a bullish stock market.

This chart is more jumbled due to the 5 Offensive Sectors, but follow along with the general patterns relative to the red S&P 500 line.

Notice how Consumer Discretionary, Technology, and Industrials mostly followed the performance of the S&P 500 all year, particularly into the close where the lines are almost identical.

Discretionary outperformed the S&P 500 for most of the year, ending as the strongest Offensive Sector with an increase of 5%.

The other interesting points are the Materials (XLB) sector which underperformed the S&P the whole year, ending down 10% and of course the Financial (XLF) sector which grossly underperformed the S&P 500, ending the year down almost 20%.

I can’t tell you how many times I heard the logic:

I’m going to buy the Financials because they’re the underperformers and just have to bounce back.

Wrong.

The main insight from the Sector Rotation Model is that sectors which are OUT-performing tend to CONTINUE to out-perform, while sectors which are UNDER-performing tend to CONTINUE to under-perform – the same logic is generally true with individual stocks.

Yes, there’s something to be said about contrary thinking, but “because something is cheap” should never be the sole reason to purchase a stock or sector – always look for other factors because without support, that which is currently cheap often continues to get cheaper.

That’s probably the main take-away from the Sector Rotation Model of 2011 – Sectors that started off strong continued to be strong throughout the year while sectors that started out weak tended to remain weak all year.  This was true for Materials as well.

For the most part, the sector performance relative to the S&P 500 (Defensive/Offensive) by May/June tended to continue throughout the rest of the year.

Anyway, continue studying the line and performance charts of the Sector Rotation Model and be ready to apply these lessons to 2012.

Corey Rosenbloom, CMT
Afraid to Trade.com

— The Option Specialist

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About the Author: The Option Specialist