Sector rotation going in to 2013 - Part 2

by Wayne Ferbert on December 6th, 2012

We like to use the State Street SPDR Sector ETFs as the best instruments for our sector investments. All nine of these ETFs have high volume, strong liquidity, and large market values. In addition, since we like to hedge, these ETFs also all have a solid options market with reliable pricing.
So, in making a decision about the sectors we like, we need to examine these ETFs in more detail. We know these sector ETFs are weighted according to market capitalization. For example, Apple is 18% of the total Technology ETF (XLK) because Apple’s market cap is so large.
Because of the market cap weighting, the largest of the stocks in each ETF tend to disproportionately drive the overall performance of the fund. So, we examined the largest holdings of each of the 9 ETFs to see what it tells us about the forward potential in 2013.
We looked at the top quintile of stocks based on the weighting in each ETF. In other words, the largest stocks in each ETF. In other words, if an ETF had 50 stocks, we looked at the top 10 largest in the ETF.
We find that the top quintile does always drive a significant portion of the performance – though some funds are more significant than others. Only one fund actually comes close to the 80/20 rule – where 20% of the stocks represent 80% of the overall weighting: that was the Technology ETF (XLK).
Take a look here at the weightings:
Technology is the highest concentration (77%) while Utilities is the lowest (42%). (Sidebar: of these industries, Utilities is the most regulated and Technology is the least regulated. I wonder what that says …)
Materials and Utilities are the lowest – as they are the most commoditized industries. The two highest are Technology and Consumer Discretionary – which are the least commoditized industries.
Ultimately, we can see these concentrations and know that the top quintile will continue to drive the performance of these ETFs. If we look back at the last year, we find that the top quintile did drive significant performance for most of these ETFs – but for some, it was more or less than others.
The top quintile out-performed the rest of the fund in the Financials, Consumer Discretionary, and Technology sectors (XLF, XLY, & XLK, respectively). The opposite was true for the Energy, Utilities, and Materials sectors (XLE, XLU, XLB). In other words, the top largest quintile companies in these three ETFs under-performed in the aggregate compared to the overall fund. For the other three sectors, Industrials, Healthcare, and Consumer Staples, the top quintile was not a meaningful under- or over-performer compared to the sector overall.
When we examine the individual holdings in each quintile within each ETF, we see nothing but bell-weather stocks. These are the largest of the large within the S&P 500. Every firm in the top quintile of its ETF is tracked by many equity analysts.  A lot of research exists for each company. In fact, Morningstar provides an equity rating for each company in the top quintile for each ETF.
If we examine the Morningstar ratings (1 worst to 5 best) for each company in the top quintile, we see some interesting data. See the chart below. 
The highest rated sector, when you examine only the top quintile, is Energy (XLE). Financials are a very close second.

The lowest rated sector is Consumer anything: Staples or Discretionary.
When you look at the standard deviation of the ratings for the equities in the top quintile of each fund, you see that Energy & Utilities have the highest. That means the ratings differences between the stocks were the most evident in that group of stocks. In other words, Morningstar forecasts a wider distribution of potential forward performance for the stocks within that group – despite the fact that they are in the same sector.
The sector with the least disagreement on the ratings (ie, the lowest standard deviation in the scores) is one of the highest rated (XLF – Financials) and the lowest rated (XLP – Consumer Staples). In other words, the Morningstar analyst ratings were the most consistent among the top quintile companies in each of these two sectors.
So, what does all of this data mean? We can’t form a definitive bias for 2013 yet – but some hypothesis could be taking shape.
The data above tells us the following:
  • Morningstar likes the stocks in the top quintile for Financials and Energy
  • Morningstar doesn’t like the stocks in the top quintile for Consumer Discretionary or Consumer Staples
  • Morningstar’s ratings are the most consistent within the top quintile for Financials and Consumer Staples
  • Morningstar’s ratings are the least consistent for Energy and Utilities
  • Within the top quintile, the Financials, Consumer Discretionary, and Technology have out-performed their peers in 2012
  • Within the top quintile, Energy, Materials, and Utilities have under-performed their peers in 2012
This is a five-part series, so we have more analysis to complete. But the early data suggests that Energy and Financials will play some part in our portfolio in 2013.
In part III, we’ll examine traditional valuation metrics for the largest stocks in these sectors and determine whether we see any potential for break-out sectors based on valuation.

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