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Getting More Out Of The Market By Using Sector Trends

Author: James Brumley (info)
Website: http://bluegrassportfolio.com
Posted: November 8th, 2006 at 11:02 pm EST
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With most of a trader’s attention being devoted to the obvious - like system trading, or managing trades - it’s easy to forget one of the simplest ideas…birds of a feather flock together. In trading terms, the ‘flock’ idea applies to stocks within a particular sector. While there’s an occasional exception, the majority of the time, a stock’s chart will look an awful lot like the chart of its overall sector. Conclusion - getting the sector trend right is half the battle. Today we’ll dig a little deeper into two sector-based strategies that, if applied properly, can make or save you an enormous amount of money.

Sector Realities

To give credit where credit is due, Bill O’Neil’s research on sectors may well be the foundation from which all sector strategies are based. If the name rings a bell, he’s the same guy who started Investors Business Daily, and wrote several books, including ‘How to Make Money in Stocks’. His study concludes that between 30% to 50% of a particular stock’s movement can be attributed to its sector. Hence, if you’re in the right sector(s) then the wind is at your back; if you’re in the wrong sector, you may well be swimming upstream.

As a basic example, take a look at a chart of the brokerage firm index (top), and then compare it to charts of Morgan Stanley (MS), Goldman Sachs (GS), Merrill Lynch (ML), and Lehman Bros. (LEH). Anybody who thought they chose well by buying Morgan Stanley shares in the middle of last year would have done just as well in any of these stocks. Like we said, birds of a feather….

Brokerage Firm Index Versus Individual Brokerage Firm Stocks - Weekly

The only other facet to keep in mind as we explore our two strategies is this….not all sectors move the same way. Oh sure - many investors and traders act as if they do, but they don’t. Some sectors, like oil and energy, tend to make prolonged moves, but can remain dormant for months and years on end. Other sectors, like the financial stocks, are highly-sensitive to economic pressures like inflation and interest rates. However, using a one-size-fits-all approach for sector-based trading can ultimately leas to disappointing results.    

With those two ideas swimming around in your head, let’s dive in to how you can get more out of the market by applying some very simple concepts. Best of all, we’ve got a couple of suggestions for how you can start using these strategies today.

Strategy 1: Sector Rotation

This is probably the more familiar idea to traders. In simplest terms, a pure sector rotation strategy is the search for - and long entry into - sectors that had been out of favor, but look like they’re being favored by the market again. Likewise, it recognizes that all good things come to an end. If a sector that had been doing well starts to weaken relative to the overall market, such a shift would prompt a trade exit….and maybe even a short entry.

Why bother? For any given timeframe, only half the sectors outperform the market; the other half under-performs. In other words, a fully-diversified portfolio is set up for mediocrity. The benefits of perfectly spotting every sector rotation trend is a portfolio that will roughly double the market’s average return of about 11%. But, let’s be realistic - perfection is out of the question. However, even tempered down to a realistic level of success, a good trader could still reap half the benefit of a good sector rotation strategy.  Would you like to beat the market by 5% to 6% a year or more? Most fund managers would, and it’s possible for you as well. You just have to use the strategy with an appropriate time frame in mind.

Where do you start? You could do the work yourself, but while it would be worth it, it would also be a burden. We recommend letting someone else do the work for you. In fact, you may have already seen it. From time to time, in the BigTrends.com Daily TrendWatch, sector rotation trends are highlighted. They’ll also occasionally point them out in the Sector Spotlight (although they try to reserve the Sector Spotlight column for specific sector charts). Take a look at past examples….

Dec. 8th, 2005 Daily TrendWatch: http://bigtrends.com/document.jsp?documentid=2636
Aug. 4th, 2005 Daily TrendWatch: http://bigtrends.com/document.jsp?documentid=2398
June 7th, 2006 Sector Spotlight: http://bigtrends.com/document.jsp?documentid=2969

Point being, if you’re serious about a sector-based strategy, be sure to read the TrendWatch on a daily basis. You never know when they might point out an important sector rotation. (like you’ll find below).

Also, we recommend you sign up for the beta trial of the new TimingResearch.com service, which includes sector rotation information. Click here: http://www.timingresearch.com/services/mtmt/

In the meantime, here’s the latest/greatest. Ranked by performance over the last two weeks, the table currently shows that healthcare is a serious laggard. It has been for a while, and the strategy assumes is will be for a while. Energy, on the other hand, looks bullish in several time frames. See any “rotation’? We do. Telecom has one of the worst longer-term performances, but has been coming on strong lately. Conversely, the financial stocks are losing their luster they boasted just a few months ago.

Recent Sector Performance Shifts, Ranked by Two-Week Performance

The key downside to a sector rotation strategy is the assumption that the top sectors will always be gaining. There are points in time when even the best-performing sectors are still losing ground. That’s the beauty of using the second strategy…..

Strategy 2: Tailor-Made Trading Systems

Like we said above, no two sectors trade the same way, so they shouldn’t be treated like they do. At BigTrends and TimingResearch.com, ten distinct proprietary trading signals  are used for each of the ten major sectors. The system used for the energy sector, like we described above, is designed to spot long-term trends, and will make the most of a monster move without whipping you in and out of short-term volatility. The technology trading system, though, specifically seeks out short-term tops and bottoms that can make the most of that sector’s volatility.

Theoretically, it’s possible for all ten sectors to be in the midst of a ‘buy’ signal. Or, it’s equally possible for none of the sectors to have a current ‘buy’ rating, if they’re all sinking. This is the advantage the strategy has over rotation….you’re not in a sector that’s losing ground simply because it’s losing less ground than other sectors.

This tailor-made sector strategy is more akin to what you’ll see in the Sector Spotlight, where one or two charts are highlighted each week, and individual merits are discussed. Like the rotation system, the strategy isn’t perfect, but it’s better than no strategy at all. So needless to say, we recommend you look at the Sector Spotlight too - even if you’re strictly a stock trader. And, the sector data piece of the TimingResearch.com beta trial also includes specific entry and exit signals designed for each sector.

Some recent examples of how the specific trading systems that were applied within the Sector Spotlight are viewable here: http://www.bigtrends.com/document.jsp?documentid=135

The bottom line is simple - if you want to get more out of the market, keep an eye on which sectors are hot, and which ones are cold.

 

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