Sector Rotation: Increase Your Sector Selection Success by 75%

The first half of 2009 has been tough on most momentum-based strategies. After declining 11.0% in the first quarter, the broad market turned around and staged a roaring rally. The S&P 500 is now up 15.7% for the second quarter.

The snap in performance between the first and second quarters is even more striking at a sector level.

In general, sectors like financials and industrials down the most in Q1 have rallied impressively in Q2. For example, Financial Select SPDR (XLF) and Industrial Select SPDR (XLI) declined 28.7% and 19.9%, respectively in Q1 to rally 38.6% and 20.9% to date in 2Q. On the other hand, Vanguard Information Technology (VGT) that bucked the decimation in Q1, advancing 3.5%, has lagged in Q2.

Sector Rotation: 1Q and 2Q2009 to Date Sector Performance

One sector where momentum has continued from Q1 to Q2 is materials. After declining a modest 1.9% in Q1, Materials Select SPDR (XLB) has gained a respectable 22.2% in Q2.

The switch in popularity of sectors from Q1 to Q2 highlights the difficultly most momentum-based strategies face in delivering consistent out-performance. The probability of success improves when one looks beyond momentum and considers other factors in sector or security selection. Such factors include news quality, valuation, growth expectations, and the like. Our research shows that the probability of selecting winners increases by 75% when multiple factors are included in sector selection rather than momentum alone.

As one looks at Q2 performance to date, the financial sector stands out as a leader. The $64,000 question is, Will this leadership continue for the remainder of Q2 and into Q3?

Viewing news quality, financial institutions are benefiting from positives like a historically steep yield curve, low borrowing costs, shrinking credit spreads, and rising mortgage originations … all of which help profitability of banking operations.

As for negatives, uncertainty on capital adequacy of banks and valuation of distressed assets remain high. Against an already high levels of non-performing loans, the rate of mortgage foreclosures and loan delinquencies hardly show signs of abating.

While one could make a case for bank stocks trading at attractive prices with respect to their longer-term earnings potential, they hardly appear bargains if one goes by analysts’ 1-year forward earnings forecasts. Citigroup (C) is expected to lose money over the next 4 quarters. Bank of America (BAC) is expected to earn just 14 cents a share and this translates to a forward P/E of over 81 for BAC’s shares. Shares of better-positioned banks like JP Morgan Chase (JPM) and US Bancorp (USB) also trade at relatively high forward P/Es of over 21.

Given moderately favorable fundamentals and unattractive valuations, the financial sector taken in toto is unlikely to maintain its leadership in market returns going forward. Selected industries and stocks within the financial sector can however offer better opportunities. Aflac (AFL), Delphi Financial Group (DFG), and Everest RE (RE) represent three promising names in the insurance group for intermediate and long-term investors.

 

Must-read Articles on Sector Investing

Using Sector Funds to Construct Diversified Mutual Fund Portfolios

High-potential diversified portfolios can be constructed by dividing assets among a group of sector funds. This approach gives the investor flexibility to over-weight or under-weight certain sectors versus broadly diversified indexes. 'Sector funds are too risky.' 'I doubled my money with Fidelity Select Technology in 12 months!' 'Avoid sector funds.' If all of this sounds confusing, you are not alone.

Sector Mutual Funds: How to Pick Winning Sector Funds and Avoid Losers

If you are looking to earn great returns from the stock market sector mutual funds are right up your alley. Sophisticated investors recognize the potential sector mutual funds offer and know how to make such funds work for them. You can consistently beat the market by investing in the right sector mutual fund at the right time. In fact, you can make money even in bear markets.

Sector ETFs: Invest in the Best Sector ETF Consistently

Sector ETFs are among the most potent investment vehicles that allow individual investors to exploit advantages previously available only to large institutions. You can beat the market by investing in the right sector ETF at the right time. In fact, you can actually make money even when the overall market is tanking. However all too often, investors use sector ETFs inappropriately and get their fingers burnt.

New ETF and Mutual Fund Recommendations

The Fidelity and ETF Core and Focus model portfolios have gained at annualized rates of 14.5% and 17.7%, respectively since 1994. The model portfolios will be repositioned with new mutual fund and ETF recommendations on Monday, September 30. Learn more about AlphaProfit's Free and Premium Service investment newsletters.

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