In earlier essays I described how to use stock charts to pick which companies are worthy and when to buy. I also shared how most of my family's investments were in stable companies with nice dividends.
I wanted to do something more interesting with my own Roth IRA. I eventually decided that my own temperament and knowledge inclines me towards sector investing.
The economy is made up of ten different market sectors. A little study allows knowing which are likely to do beter than average.
We can think of sectors as sports teams and stocks as athletes. Predicting if a certain athlete will have a good day, week, or month is hard to do. But that same kind of prediction can often be made for an entire team.
In other words, stock prices jump up and down so much that it is difficult to know which stocks to root for, and "chasing gains" with stocks is a recipe for failure. But sectors contain so many stocks that the jumpiness is dampened. A well-informed investor can determine which sectors are currently favored.
An investor can do better than the overall stock market by buying more of the more-favored sectors and less of the less-favored sectors.
The analysis to determine which sectors are more-favored or less-favored should be done every three or four months. It takes very little work each year to keep the investment account updated.
Do not be alarmed that I am simplifying a bigger issue. Not all economists agree on how to best divide up the economy into sectors. This should not be surprising. Economics is not a hard science. Economists disagree about nearly everything!
The sector named Technology is sometimes called Information Technology. Sometimes Real Estate is a sector. Sometimes Telecommunications is not its own sector but is part of Technology. Some stock market cycle diagrams swap the always-adjacent sectors Telecommunications and Consumer Staples. But just because economists cannot even agree on how many sectors there are does not mean sector investing is not old and respectable.
How do we know which of the ten sectors are more-favored and which are less-favored?
Unfortunately, there are no concrete mathematical formulas to measure or predict such trends. We can only guess. Yet we can make some very educated guesses. The sectors are easy to analyze and study. We can have enough information to usually guess well.
Moreover, we are only trying to guess "good enough". For my particular style of sector investing I only try to assign one of four labels to each sector:
So my first layer of "good enough" is that my specific goal for each sector is not very demanding. I am not trying to measure a sector's status precisely. I only want to sort the sectors among four possible labels.
My second layer of "good enough" is that my overall goal for investing is not very demanding. I am not trying to label each sector correctly every three months. I only want to earn more than the overall stock market. If for a particular three-month time period I can assign slightly wrong labels to several sectors but still achieve my overall goal.
Now let us examine the tools we use to determine which sectors are likely to be favored.
Our first tool in analyzing the sectors is the business cycle.
An analysis of cycles and sectors by Fidelity describes the business cycle. This is a slow, chronological movement of employment, credit, inflation, etc.
The same Fidelity analysis also shows when sectors historically have done well compared to the overall stock market.
Remember that these plusses and minuses are only tracking comparitive advantage. For example, the Telecommunication sector has a plus during a recession not because it is wildly profitable then, but because everyone still uses their cell phones during a recession so compared to the overall market that sector has done well in recessions.
This chart is not completely reliable. For example, as this essay is edited in June 2014 the business cycle is Early but the Energy sector strongest because of how technological and political developments are allowing exploration and speculation.
Yet this suggests three or four sectors as likely to be more favored, and two or three sectors that are likely to be less favored.
Our second tool in analyzing the sectors is the stock market cycles.
The stock market cycle is loosely linked to the business cycle. Stocks tend to do well when the economy is strong and poorly during a recession.
Yet the stock market has other influences. Most notable, people transfer their investments back and forth from stocks to bonds and real estate. The attractiveness of bonds and real estate can push the stock market cycle apart from the business cycle. For example, high interest rates cause bonds to be attractive and will prompt people to sell stocks even during a time of economic growth.
Furthermore, people transfer more investments into stocks slowly, after the stock market has begun to do well. They transfer investments out of stocks quickly, after the stock market begins to decline. In other words, there is a lopsided sawtooth shape instead of a symmetrical mountain range shape. Bull markets grow slowy, but the Early Bear market usually happens very quickly as investors flee from stocks into bonds and real estate.
Historically, different sectors are more likely to be favored at different times during the stock market cycle.
(I made the above diagram. You can find other slightly different charts.)
We cannot always tell where the country is in the stock market cycle. Normally this diagram is used to narrow the current conditions to two of the four quadrants pictured above. So we find another suggestion of four to six sectors as more likely to be favored, and the other sectors as less likely to be favored.
Our third tool in analyzing the sectors is considering the economic news about each sector.
We should read a bit of financial news to look for atypical trends that affect any of the sectors. Even knowing a little about consumer spending, political activity, and economic crises can help. Perhaps there will be other obvious items of importance (such as the previously mentioned boom in energy-related exploration and speculation.)
Clicking on the sector names in the previous Fidelity link leads to news articles about each sector. Seeking Alpha gathers all of its sector news conveniently on one page. The Telegraph has sector news. Financial Times has a little sector news if you scroll down and use the pull-down options to pick each sector in turn.
Our fourth tool in analyzing the sectors is to check which sectors have been doing the best lately. Remember that it is possible "chase" sectors because their behavior is not too jumpy.
The website SectorSpdr has a graphing feature that shows how each sector has performed compare to the S&P 500 during the past three months. The graphs will quickly reveal which sectors are consistently above or below the S&P 500, and which are doing okay but do not inspire much confidence.
Recent growth is no guarantee of continued growth. But strong performance does suggest that certain sectors as more or less likely to be favored.
Hopefully these tools are beginning to work together. We hope the business cycle, stock market cycle, economic news, and recent performance will agree on which sectors are most likely to be favored during the next few months.
I also like to use Google's widget to see all ten graphs at once.
Another resource is how websites such as Fidelity, Vanguard, and Seeking Alpha provide summary information but not such nice graphs.
Our fifth tool in analyzing the sectors is Raymond Tsang's proprietary measurement. His website has Sector Trend Charts that use the moving average and trade volume to offer a slightly different quick take on the previous few months' behavior.
Since Tsang does not reveal his methods we should not trust them much. But we welcome additional confirmation of any apparent trends.
Our sixth tool in analyzing the sectors is comparing how "bullish" (busily full of investor's money) people have been compared to each sector's actual performance.
Separate graphs for each sector bullishness are available at StockCharts.com as a CandleGlance preset.
A summary graph requires a Fidelity account to access this web page.
If the sector has better performance (blue line) than bullishness (green line) it is underinvested and more likely to be favored. If the sector has much less performance than bullishness it is overinvested and less likely to be favored.
Again, this tool cannot predict future sector strength reliably, but can add evidence to support trends we observe.
Our seventh tool in analyzing the sectors is whether they are undervalued or overvalued.
The quarterly reports by JP Morgan entitled Market Insights: Guide to Markets have a page providing the Forward P/E and the Fifteen-Year Average P/E for each sector.
The percent change is called the Forward P/E Difference.
Forward P/E Difference = ( Forward P/E − 15-year Avg. P/E ) ÷ 15-year Avg. P/E
Compared to average historical prices, are the short-term predicted prices for that sector's stocks low or high?
A low number shows that prices in that sector are currently undervalued, making that sector more likely to be favored. A high number shows that prices in that sector are currently overvalued, making that sector less likely to be favored.
Those seven tools provide a lot of information! Time to make our well-educated guesses. Do we consider each sector strongly favored, slightly favored, slightly out of favor, or strongly out of favor?
Here are my guesses as I write this essay at the end of 2013. Do not trust me! How would you rate the sectors for the first quarter of 2014 after you do your own analysis?
Example: Ratings of Favor for 12/20/2013
Sector Rating Consumer Discretionary strongly favored Technology slightly favored Industrials strongly favored Materials slightly out of favor Energy strongly out of favor Telecommunications strongly out of favor Consumer Staples strongly out of favor Health Care slightly out of favor Utilities strongly out of favor Financials slightly favored
Note that the ten sectors do not divide up the economy into equal tenths. Our next step is to look up how much of the economy is within each sector.
Example: Market Weights on 12/20/2013
Sector Market Weight Consumer Discretionary 12.54% Technology 18.03% Industrials 10.99% Materials 3.49% Energy 10.30% Telecommunications 2.30% Consumer Staples 9.92% Health Care 13.11% Utilities 2.96% Financials 16.36%
Investing in the sectors in those proportions would be nearly the same as investing in the S&P 500. Instead we want to increase the proportion of the favored sectors and compensate by decreasing the proportion of the others.
Time to assign numbers to how we rated each sector's amount of favor.
Next we multipy the market weights of sectors by their ratings. This gives us adjusted weights.
(You can use whatever numbers you wish. I purposefully do not allow myself a ×1 amount because the prohibition on calling any sector "average" makes me do more analysis. You might be different. Also, you could use an additive adjustment to the market weights instead of a multiplicative adjustment.)
The total weight is no longer 100%! So we add up the adjusted weights, and divide each of them by that total. This recalibrates so the values once again add up to 100%. I round these recalibrated weights.
Example: Calculating the Recalibrated Weights for 12/20/2013
Sector Market Weight Adjusted Weight Recalibrated Weight Consumer Discretionary 12.54% × 2 = 25.08% ÷ 1.0695 = 23% Technology 18.03% × 1.5 = 27.05% ÷ 1.0695 = 25% Industrials 10.99% × 2 = 21.98% ÷ 1.0695 = 21% Materials 3.49% × 0.5 = 1.75% ÷ 1.0695 = 2% Energy 10.30% Telecommunications 2.30% Consumer Staples 9.92% Health Care 13.11% × 0.5 = 6.56% ÷ 1.0695 = 6% Utilities 2.96% Financials 16.36% × 1.5 = 24.54% ÷ 1.0695 = 23% Total: 106.95% 100%
The hard work is done. I simply divide my Roth IRA money in proportion to those recalibrated weight and buy the appropriate sector ETFs.
Because I use a Roth IRA, there are no taxes on capital gain or loss and I do not need to worry about wash sales. I can be really lazy each quarter of the year. No need to calculate how much of each sector ETF to buy or sell. I just sell all the sector ETFs in my Roth IRA, and then rebuy the new ones in the proper amounts.
Note that Fidelity, Vanguard and SectorSpdr offer index fund ETFs that try to follow the sectors. Depening upon which brokerage firm you use for your investments, one of these options probably has the lowest—possibly zero—fees to buy and sell the funds.
(There might be other companies that offer sector ETFs. I may not know them all!)
Financial firms also offer mutual funds that follow the sectors. But these usually have higher expense ratios than the ETFs. The mutual funds used to be useful because only they could be bought and sold without fees. But that has changed as ETFs have become more popular.