How "Sector Rotation" Shows You Which Basket to Put Your Money In

What weighs more... a pound of feathers or a pound of gold?

You may remember this schoolyard trick riddle... The answer, of course, is that they weigh the same.

Or do they?

Actually, gold is traditionally measured using a different weight system - the troy ounce, which weighs 31.1 grams as opposed to 28.35 grams for the regular, or avoirdupois ounce. You would think that would make a pound of gold heavier - but it's not, since there are only 12 ounces in the troy pound. So that ultimately means a pound of feathers weighs more.

Pretty cool, huh?

I've been thinking about this old riddle lately as I watch money move in and out of different market sectors... creating, if you will, a "heavier pound" in one place or another. This phenomenon is called "sector rotation."

Sometimes - as with the heavier feather example - the bulk of the money lands in places you wouldn't expect.

In the past, I've described ETFs as "baskets of stuff" that trade like individual stocks. So looking at the top stock holdings that make up the "baskets" will help us understand why these ETFs trade like they do.

And when you know what's in these ETFs - and which ones are underperforming or outperforming - you'll be able to translate that knowledge directly to your portfolio...

Here Are the Sector ETFs to Watch... and What's in the Baskets

One of the intermediate-term indicators that I always keep an eye on is sector rotation.

This term - sector rotation - is just a shorthand way of saying which sectors are performing better at any given time.

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I believe that we can understand some of the positioning patterns of investors and traders when we see where money is flowing.

And right now, the changes that are taking place give us a very good clue to market health. To get to that insight, let's look at the long-term and the short-term performance of the nine major S&P sector exchange-traded funds.

In the chart below, we see the performance of the nine ETFs relative to the S&P 500 for 2017. I'm showing this chart up through the 28th of November because that was the date that we started to see a swing in sector rotation:

10MMChart1

Here we see that the tech sector far outperformed, the energy and consumer staples significantly underperformed, and all of the other sectors were within 4% of the S&P 500's returns. I'm guessing that outcome is not too surprising to anyone who has been keeping an eye on the markets this year.

But let's take the time to look at what is really in these sector ETFs, or "baskets."

For example, the tech ETF symbol XLK has the following top holdings:

10MMChart2

I'm guessing most items on this list will not surprise you. That Apple, Microsoft, Facebook, and Alphabet make up 43.6% of the ETF is expected. However, knowing that payment networks like Visa and Mastercard and Internet service providers like AT&T and Verizon are included is fairly interesting.

The energy ETF with the symbol of XLE is equally uncomplicated in its holdings:

10MMChart3

The big vertically integrated oil majors like Exxon, Chevron, and ConocoPhillips make up the bulk of the index. Oil services companies like Schlumberger and Halliburton and other less integrated companies round out the list.

The consumer staples list is, on the other hand, a little more interesting:

10MMChart4

In the consumer staples area, product producers like Procter & Gamble (maker of Tide, Pampers, Crest toothpaste, etc.), Coca-Cola, and PepsiCo are prevalent, as are tobacco producers (Philip Morris and Altria). Then the big consumer goods retailers weigh in - Walmart, Costco, CVS, and Walgreens. With this group, it's easy to see that this sector deals with the stuff people buy every day. So it's less sexy during high-growth periods and more interesting to investors during market pullbacks. Which comes into play in our analysis below.

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How the Sectors Have Shifted, and Where to Put Your Money Now

The markets have shown a very unique pattern since the Thanksgiving break. Market-leading tech stocks have had two significant down days.

By itself, this could be a troubling development. But this breather in the tech onslaught has been met by a resurgence in three sectors: financial, consumer staples, and industrial.

We see this sector rotation that has happened since the end of November in this chart that shows the percent change in the nine major S&P sector ETFs:

10MMChart5

In the chart above, the number "1" shows that tech has been lagging as profit-taking has hit the sector. You can see this as the lime green line is near the bottom of the page.

We also see at number "2," the top sector - financials - showing strong outperformance as traders and investors anticipate this sector to benefit most from the combined effect of the tax rate reduction and regulatory easing. This is one of the key sectors to watch as a sign of intermediate-term confidence in the Trump growth narrative.

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Significantly, number "3" highlights that the two worst long-term performers (consumer staples and energy) are both now outperforming the broader market as tech takes a dive.

This is actually a very healthy occurrence. Money has been taken out of the sector that has been the strongest all year - technology - and instead of heading to the sidelines, that cash has rotated into other sectors that either needed to catch up (consumer staples and energy) or had the most promising prospects heading forward (financials, due to tax reform plus reduced regulation, and industrials, due to the growing economy and prospective infrastructure spending).

The bottom line? The market refuses to give us very many reasons to doubt the grinding bull market's ability to grind up further into the end of the year and beyond.

I've talked with several traders who are looking for market pullbacks in the near term. This would not be surprising, and a 3% to 5% drop would be quite normal. Without any outside trigger event like geopolitical unrest occurring, I think the probabilities for such a pullback are much greater in the new year than during the rest of December.

As support for this assertion, we have the fact that December has been, on average, the strongest month of the year over the past 89 years - averaging a 1.54% gain in the S&P 500.

And here's a very fun (and useful) fact - Bloomberg reports that in that same 89 year stretch, December has never been the worst-performing month!

This doesn't mean that we should throw caution to the wind. But it does mean that we should honor the bullish momentum until the market's price action gives us reason to make adjustments to our strategy.

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The post How "Sector Rotation" Shows You Which Basket to Put Your Money In appeared first on 10-Minute Millionaire.

About the Author

D.R. Barton, Jr., Technical Trading Specialist for Money Map Press, is a world-renowned authority on technical trading with 25 years of experience. He spent the first part of his career as a chemical engineer with DuPont. During this time, he researched and developed the trading secrets that led to his first successful research service. Thanks to the wealth he was able to create for himself and his followers, D.R. retired early to pursue his passion for investing and showing fellow investors how to build toward financial freedom.

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