Sector Rotation for the Hedged Investor

by Wayne Ferbert on October 31st, 2011

If you have read our recently released book, Buy And Hedge: The Five Iron Rules for Investing Over the Long Term, then you know that we are strong believers in Indexing and we like to use ETFs to create our index exposure. And as the title clearly states, we invest for the long-term. We don’t look to time the markets in any way shape or form. Our book advocates that around 50% of your portfolio should be invested in broad market indexes – and be hedged.

But that still leaves the other 50% of your portfolio to find targeted investments. And we advocate concentrating some portion of the remaining portfolio to sectors that you think will out-perform the broader markets over the horizon. Our horizon is generally one year or more. This approach is often called sector rotation.

Whenever you meet a money manager that uses sector rotation, you’ll almost always find that he relies mostly on fundamental analysis or technical analysis when deciding which sectors to concentrate his assets under management. Within our advisor business, we focus on fundamental analysis for choosing our sector concentration.

We pick the sectors we like AND the sectors we want to avoid using our fundamental analysis. In picking our sector bias, we strictly limit ourselves to the fundamentals. So we create our long biased sector positions based on the fundamental analysis. But technical analysis does come in to play when we decide to exit our sectors. When a sector has a strong run in either direction, we recommend you compare that run to the broader market in determining whether it may have reached its limit or your target price for exit.

Let’s look at our current bias. Technology, Consumer Staples, and Energy are the three sectors that we have been long biased. So, we look for solid companies in these sectors. And even if we don’t find a specific company that meets our tight value bias, we still create long exposure to the sector using broad based ETFs while we look for these companies. In particular, the Sector SPDR ETFs have these three sectors covered nicely with the XLK (Technology), XLE (Energy), and XLP (Consumer Staples). And these 3 ETFs all have a robust options market which makes it easier to hedge them.

Looking at the chart below, these three sectors have done nicely in 2011 YTD as all have out-performed the S&P 500 (SPY):
But as we study the recent market rally, we see the star performer from this chart is beginning to look a little long-toothed for this rally. The Consumer Staples (XLP) sector has been up about 8% YTD. But in the recent rally of the last month, Consumer Staples has significantly under-performed all of the other sectors.

If you believe that the recent rally is a bit of a relief rally associated with improved investor sentiment relative to a U.S. economic recovery, then Consumer Staples will almost certainly under-perform the broader market going forward. If you think the global and US recovery is still far from certain, then Consumer Staples is still a safe place to be – but don’t expect a significant out-performance given its 1 year run its already had. After all, Consumer staples usually are lower margin companies with steady revenue profiles. Rarely do they run very high or very fast.
We still like Consumer Staples. But would advocate taking a little profit off the table if you have been in the broader sector ETFs like XLP. And if you are thinking about putting on a new stock position in Consumer Staples, make sure the investment hypothesis considers the potential for an economic recovery. In fact, we recommended Safeway (SWY) back on October 14th in this article: How (and when) to Use Sector ETFs to Hedge.

If you put on the Safeway investment back on the 14th at the close price that day, you’d be up 12%. And if you followed our article and put on a sector hedge, that hedge would not have moved much as the sector is up less than 2% over the same time frame. Few were brave enough to predict the strong move in the broader markets OR the Safeway move this fast. And Iron Rule #5 in our book is to Harvest your Gains and Losses. So, we should consider that here.

I recommend the following. We still like Safeway (SWY) and still recommend being long the stock. We expected Safeway to out-perform the broader Consumer Staples sector. We just didn’t expect it to out-perform it in only 2 weeks by more than 10%. So, since the hedge was built in the sector ETF and that has not moved much in value, we recommend that you remove that hedge and sell it while it still has most of its original value. Take those funds and re-invest them in a hedge in Safeway directly. SWY has a liquid options market – so find a married put option. And think about making the hedge a little tighter than usual – maybe protect your downside a little more than usual. This run-up has been fast and it has coincided with a broader market move. Let’s lock in some gains.

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