Sector rotation Going in to 2013 - Part 1

by Wayne Ferbert on December 5th, 2012

Sector rotation is a popular strategy on Wall Street. It involves picking the winning sectors from the broad market and concentrating your portfolio towards those sectors. We deploy this strategy at Buy & Hedge and implement it for several of our clients.
One of the reasons we like it: as they are broad sectors, the investment risk is muted because you are investing in a whole sector – not trying to pick the stock winners within that sector. The latter is more difficult. And since we invest a large portion of our strategy in the S&P500, the sector investments represent just a component weighting making their impact smaller on the overall portfolio value.
So far in 2012, the sector rotation we have written about on this site has worked out to a small improvement in performance. We have been over-weight in Technology, Financials, and Energy all year.
Technology, despite being one of the worst performers over the last 3 months, is still beating the S&P 500 year-to-date: +15% vs. +12.5%. Financials have been the best performing sector of the year: +22%. Lastly, energy has been a disappointment at +3%. Energy has had a nice 2nd half of the year as it has out-performed the S&P 500 by 4% since June 1st. However, it was a difficult ride in energy on its way down to that early June low.
It is nice that 2 out of our 3 picks beat the market so far in 2012. But being a successful investor is more about looking forward than about looking backwards. So, the big question is: what sectors will we prefer in 2013?
This is part 1 of a 5 part series focused on the analysis required to determine our favorite sectors in 2013. We are going to analyze the key valuation ratios of our favorite sector ETFs (SPDR Sector ETFs from State Street) and the largest stock components of those ETFs.
The sector concentration decision is an important part of improving the returns in your portfolio. Don’t believe it? Look at the chart below. It shows the different implied growth rates in the Operating EPS for the S&P 500 overall and the 10 sectors that make up the index. 
The variability is amazing. The 2012 growth over 2011 shows tremendous variability (The 2012 EPS in this chart includes actuals for Q1 & Q2 and estimates for Q3 & Q4). The expectations for 2013 over 2012 are even more surprising. The implied 13% growth in 2012 for the overall S&P500 seems particularly optimistic. But the forecasted variability between the different sectors is just as high as the actual variability we have experienced this year. Of course, no sector forecasts a decline – but we know that won’t likely be the case in 2013.
If this is the variability in the forecasts from Standard & Poors, you can bet the actual index equity price performance by sector is going to have an equally significant variance. Hence, picking the winners is important.
In Part 2 of this series, we will drill down on the component companies that drive the sector performance – and see if the earnings growth implied above is believable.

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