Monitoring sector performance is a powerful way to get a beat on the themes in the market. Since prices move before fundamentals, following sector rotation and understanding why it’s happening is a critical input into the investment process. Many variables impact sector performance including economic trends, company fundamentals, valuation, money flow, and macro asset prices (e.g., bond yields). Analysis of sector rotation provides insight into how these variables are evolving. The key takeaways are:

  • In general, there are no significant changes to sector leadership over the medium term (YTD). The sectors and subsectors that have outperformed heading into 2018 continue to outperform.
  • On a sector basis, Tech (XLK)+14% and Consumer Discretionary (XLY) +13% are leaders YTD vs. the SPY +6%. Consumer Staples (XLP) -5% and Telecom (IYZ) -3% are the biggest laggards.
  • Cyclicals sectors like Industrials (XLI) -2% and Materials (XLB) -2% have performed weaker YTD vs. 2017. This is due to emerging markets weakness, and deceleration of global growth from high levels.
  • Financials (XLF) -2.6% also performed weaker YTD relative to the previous trend. Financials probably represent the best opportunity for a bounce relative to the market in the next 3-6 months if the US economy maintains its growth trajectory.
  • On a subsector basis, Internet (FDN) and Biotech (IBB) are performing better YTD vs. the prior trend. Homebuilders (ITB) are underperforming, which may be an opportunity to buy them at the lower end of their trend.

Sector Rotation Themes

One way to measure sector rotation is to compare the performance YTD vs. 12 months to see what’s changing. A scatter plot is a useful way to accomplish this, and you can easily create scatter plots in Koyfin.

In the chart below, the x-axis shows the 12-month performance and the y-axis shows YTD performance. Sectors that are leaders YTD are also leaders over the past 12-months. Similarly, sectors that are laggards YTD are also laggards over the past 12-months. This suggests that momentum has remained consistent over the past year, without much change in sector leadership. Investors continue to buy the strongest sectors (based on performance) and underweight the weakest. This can also been confirmed by the fact that all the sectors fit the regression line very closely.

Source: Koyfin. To create a scatter plot like this in Koyfin, create a monitor with the sector ETFs, and then use the Market Scatter (MS) function to select the monitor. Then set the x/y axis to historical % change. See video demo

Sub-sector Rotation

On a subsector basis, momentum is also a dominant theme YTD, but there is some dispersion as indicated by the fact that some subsectors are further away from the regression line. For example, the YTD outperformance of Internet (FDN) and Biotech (IBB) has accelerated vs. the performance over the past year. On the flip side, the performance of Homebuilders (ITB) has lagged sharply YTD relative to the performance over the past year.

Source: Koyfin.  To create a scatter plot like this in Koyfin, create a monitor with the subsector ETFs, and then use the Market Scatter (MS) function to select the monitor. Then set the x/y axis to historical % change. See video demo

Internet (FDN) has been the best performing subsector YTD with a 32% return, which represents a 25% outperformance vs. the market (SPY). The outperformance has accelerated YTD vs. the prior trend. So what to do with internet subsector? Typically, it’s a good idea to be long stocks which are going up. The fundamental backdrop for the internet stocks is strong over the next several years as media consumption and advertising dollars shift online from traditional channels. However, from a near term risk management perspective, it’s important to keep in mind that if the momentum factor pulls back or reverses in the near term, Internet stocks will likely be the most negatively affected given their strong recent performance.

Source: Koyfin. Click here to pull up this chart in Koyfin

Financials, Industrials and Homebuilders are attractive longs to consider after the recent underperformance

For Financials (XLF), the YTD performance has been weaker than the prior trend with the sector underperforming the S&P 500 by 10% YTD. On a relative basis, the XLF is near its 18 months support, and back to where the sector traded on a relative basis post the presidential election. The fundamental backdrop for Financials is fairly bullish, with a strong economy and financial regulatory rollback. Financials are also one of the most domestically focused sectors and are largely immune to recent market concern surrounding a trade war. For the sector to continue to underperform, several macro shifts will need to take place, including weaker credit markets, economic slowdown and sustained high volatility (risk aversion). To the extent there are no major macro shifts, Financials are a good candidate for a bounce back in the second half of 2018.

Source: Koyfin. Click here  to pull up this chart in Koyfin
Industrials (XLI) sector is down 2% YTD. One of the reasons for the underperformance is macro concerns related to emerging markets worries, and the Industrials sector is among the most exposed to emerging markets growth (e.g., CAT, HON). Another reason is that GE is a 5.4% weighting in the sector and down about 20% YTD. Of the -2% YTD performance for Industrials, GE accounts for about -125 bps. (To see attribution on Koyfin, you can use the Holdings (HDS) function and look at the attribution.) On a technical level, the relative performance of XLI is near the bottom of its 15-year range, and seems well set-up for outperformance later this year.

Source: Koyfin. Click here  to pull up this chart in Koyfin

Homebuilders (ITB) is another subsector that looks like an attractive candidate to consider after the pull back YTD. ITB has underperformed the SPY by 17% since the start of the year, reversing about half of the 2017 outperformance (where the sector outperformed by 38%). On a macro level, Homebuilders should benefit from low unemployment levels and pent up demand for housing caused by tepid supply. (We plan to release a more detailed research post about housing in the near future.)

Source: Koyfin. Click here  to pull up this chart in Koyfin