Sector Rotation from Staples to Financials

by Jay Pestrichelli on February 29th, 2012

If you’ve followed us for any time, you know that at Buy and Hedge we like to keep 50% of a portfolio in broad-based ETFs for general market exposure. This leaves 50% of the portfolio to but that still leaves the other 50% of your portfolio to find targeted investments. We advocate concentrating some portion of the remaining portfolio to sectors that you think will out-perform the broader markets over the horizon.

Back on October 31st we discussed this methodology and called out a few sectors that we thought created the right blend for an opportunity to outperform the S&P500. At that time we highlighted 3 sector ETFs: XLE: Energy, XLK: Technology, and XLP: Staples. You can read that post titled: Sector Rotation for the Hedged Investor.

The thesis was that tech and energy were poised to lead any rebound. We also stated that one of the best performers, consumer staples, had probably made its run and that if the US went through a recovery this sector would underperform.

Turns out that write up was 3 for 3 and although we never called out entry and exit points, the sectors performed as expected.

As usual when we look forward, its time to reassess. Below is a chart of the major sectors over the last 6 months. Tehc, Industirals, Cyclicals, have shown to be the lead pack all moving up more than 16%. Energy, Financials, and Healthcare grouped up next performing between 10–12%. Followed by the lagers, Staples, Real Estate, Utilities, and way at the bottom, Materials.

We’re still going to keep energy and tech as core to our holdings as the fundamentals that drive them haven't changed. Energy will continue to be in demand and if there are any conflicts in the Middle East, oil acts as a nice hedge. Not to mention as the US continues through its recovery it will add demand. Tech advantages are that as companies start to re-invest in themselves, they will most likely first invest in upgrading their efficiencies before adding bodies. Also, the prospects of the cloud and mobile services seem to have no limit in site.

Our estimates about the staples were confirmed these past few months and we think that this sector has had its run and we’ll start to rotate out of it. Instead we’re going to add some risk to our portfolios and enter into the financial sector.

There are lots of reasons to be concerned for the financials, the biggest is the environment of prolonged low interest rates. Add to that regulation changes have added pressure to their earnings models and that they still have many more foreclosures to process, and we watch investments here very carefully.

The case for owning the financials though stems from the knowledge that the worst is behind them. While the headwinds just mentioned still exist, they are known entities and shock to the stock prices has already been felt. Addionaly, the troubles in Europe seem to be under control and the organized default of Greek debt shows that our partners across the pond are taking deliberate steps to keep the union together.

The past 3 months have shown these factors can generate returns and we keep in mind that no true market rally can happen without this sector participating in it and driving it. We’ll expand more on why the financials make sense in later posts, but for now we are going to systematically move assets into XLF out of XLP(Staples) and of course hedge every position we take.

On a side note, we considered the cyclicals (aka: consumer discretionary), but we think we need to see more evidence of stronger housing, better unemployment and lower prices at the pump. This sector will outperform as the market continues its bull run, but we think we’ve taken enough risk adding the financials to the portfolios to do a double whammy.

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