Monday, April 25, 2011

ETF Ranking, Sector Rotation, And Business Cycle

As discussed in previous posts on ETF Ranking and Sector Rank Spread, the fundamental ranks of sector ETFs measure the tendency of money flowing out of lower ranked sectors and into higher ranked sectors. Actually there is a term for this phenomena: Sector Rotation. During a business cycle, the underlying structural changes will drive certain sectors to outperform while others to under-perform. Different phases favor different sectors. I borrowed from MarketScalpel a chart that shows the sector rotation model. MarketScalpel did a good job of maintaining a list of various resources (even including an academic papers) on this topic. Read more here if you are interested.

If we put this chart side by side with the ETF ranking chart, we see XLE is the top ranked offensive sector and XLV is the top ranked defensive sector. Where are these two sectors locate in the business cycle? The late expansion phase. See below for the ETF ranking chart.

As their ranks are still high comparing to other sectors, we may still be in the beginning of this phase. But I would recommended to stay cautious as the next phase will be in recession. A contraction of the sector rank spread would be a flashing yellow light. Or if XLU, the sector that will outperform in the next phase --- the early recession phase, replaces XLV to be the top ranked defensive sector.

That said, the SRS still expanded a little bit last week. So maybe we still have a couple of months or even years to indulge ourselves.