Understanding Sector Rotation: Technical Analysis 101

BALTIMORE (Stockpickr) -- You rotate your tires. Farmers rotate their crops. And smart investors rotate the names in their portfolios. Do you?

Asset rotation is one of the most powerful tools you can put into your investing arsenal, so it figures that it's also one of the most misunderstood.

As an investor, the idea of sector rotation sounds simple enough: It's the practice of shifting allocations from one sector to another to beat the broad market. But while describing sector rotation is simple enough, implementing a sector rotation strategy for your own portfolio is a whole different story. In this technical primer, we'll take a look at how sector rotation works and how you can tell when it's time to rotate your own investment mix.

To start, "sector rotation" really isn't the best term to describe what we're doing here.

While the term gained popularity among mutual fund managers, who were locked into stocks by their funds' restrictions, rotation is by no means limited to the stock market. Instead, sector rotation can really be applied to all asset classes, including bonds, commodities and even cash.

So while "asset class rotation" is probably a better term, we'll stick with the regularly accepted nomenclature for the time being.

One of the keys to sector rotation is the idea that all markets (or asset classes) are connected. That's not some sort of new-age concept -- rather, it has a lot to do with the flow of funds from investors to the marketplace and with aggregate supply and demand. It's important to remember that investors' resources are finite. That means that investors have to make a choice about where they plant their assets; capital flowing into one asset class (such as stocks) generally means that capital is flowing out of another (such as cash deposits). It's that relationship that's core to sector rotation.

Understanding Broad Market Relationships

To know how to rotate between assets, it's necessary to be a little more familiar with how the relationships between different markets (known as intermarket relationships) work. The simple version breaks the market down into three markets: bonds (or interest rates), stocks and commodities.

Generally, bonds lead stocks, and stocks lead commodities. In other words, a typical investment cycle consists of a bond rally, which is followed by a stock rally, which is then followed by a commodity rally. The opposite is true as well: Weakness in bonds generally precedes weakness in stocks, which precedes weakness in commodities. Not surprisingly, these relationships are due in large part to the causality between these different markets. For instance, stocks might be in the middle of a declining phase as rallying commodities increase input costs and put the squeeze on companies' profit margins.

Even though these relationships are a good simplification of the investment cycle, they're not infallible. Just because they hold true now doesn't mean they'll hold true in perpetuity, so it's important to stay on top of market relationships if you're taking an active approach to asset rotation.

As useful as it may be to know how the investment cycle operates, the most crucial piece of the puzzle is still missing: How do you know when to rotate into or out of a particular sector or asset class?

Trading Signals for Your Asset Rotation Strategy

Traditionally, relative strength has been one of the most popular ways of determining which sectors are worth watching. Basically, relative strength is calculated by taking the ratio of one security’s price over another's. While the resulting number is fairly meaningless, its change over time is very significant -- and uptrending charts of this metric mean outperformance is occurring in the numerator security. By using a moving average crossover signal to determine when that uptrend is broken, it's possible to get solid, mechanical buy and sell signals.

The relative strength chart below of the S&P 500 Index vs. Gold is in a well-defined uptrend. That's a signal that investors should have been actively rotating out of gold and into equities. Until that uptrend breaks, that's the long-term trend in play.

The fact that (traditional) relative strength can only compare two securities at a time means that a number of charts have to be analyzed to find the “winning” asset class -- but the objective buy and sell signals are a huge benefit to anxious traders.

A more anecdotal method involves taking a look at the performance of different sectors and asset classes over a given period to determine where in the investment cycle we are. Based on the intermarket relationships we talked about earlier, a bond rally turning south coupled with increased buying in stocks could mean that equities are about to start a more sizable run. Within stocks, comparing sectors that are historical leaders or laggards can point investors in the right direction as to which sector to be heavy on and which to avoid. When a leading industry such as transportation starts to see an uptick, it may be a good indicator that it's time to take a position in later-stage industries such as consumer staples. (Martin Pring’s book Technical Analysis Explained provides an excellent table of industries grouped by their leading or lagging effects during cycles.)

For more sophisticated investors, there are a number of proprietary models that are designed to determine what stage of the investment cycle we're in -- and to help allocate a portfolio accordingly. Generally speaking, though, these models are either incredibly expensive to license or incredibly complex to implement. As such, they’re generally relegated to professionals. For most technicians, the first two methods offer a much more accessible way to employ asset class rotation, often with better results.

Recently, the introduction of the Relative Rotation Graph, or RRG, in 2011 by Julius de Kempenaer has added a distinctly visual element to analyzing relationships and rotations between asset classes. RRG charts are now available free via StockCharts.com.

This Relative Rotation Graph of S&P 500 sectors shows their clockwise rotation from lagging to leading. In the chart below, consumer discretionary stocks are distinct leaders, while utilities are lagging the worst.

While “sector rotation” is a common phrase on and off Wall Street, implementing it effectively requires a bit of uncommon knowledge. Now you should be set to allocate your portfolio in line with sectors or asset classes exhibiting strength -- and be aware of which are likely to be next in line for a move higher.

This article is commentary by an independent contributor.

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