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The Case for Sector Rotation

1 February 2014

Dorsey Wright and Associates

There is always plenty of banter regarding “market timing,” how important it is, how hard it is, whether it’s an effective use of time and effort, etc. Depending on the prevailing market winds, temperament oscillates from rampant envy of those that appear to have mastered the art of market timing (and everyone wanting to be a market timer themselves), to outright eschewing of the whole market timing hullabaloo. As we’ve said many times over, however, the real story is not whether one can consistently be effective at “market timing,” let’s just chalk that up as a timeless debate, but instead the far greater tactical opportunity for advisors is that of Sector Rotation, which is the real story. We could spend all of our effort dispelling the practice of “Buy & Hold” practices, strategic pie allocations, pure Market Timing, and the likes … or we could just further the case for sector rotation, which is what we’ll do today.

In constructing our first table, we started back in 1993 with $10,000. We then applied four different equity strategies: Buy and Hold, Perfect Market Timing, Buying the Best Performing Sector (each year), and Buying the Worst Performing Sector (each year). For the first two scenarios, we used the returns of the S&P 500; and for the sector timing strategies, we used the returns from the Dow Jones Sectors. This study presented below is one that we have published for years and it simply tracks the outcome of those four hypothetical investors (as described above). Each of our four investors has different outcomes based upon how they invested, the image below simply shows the results, and in turn illustrates the opportunity afforded to those willing to seek strong sector themes and not just ideal market timing.

The first investor is who we’ll term, “the buy and holder.” He just buys the S&P 500 and rides it up and rides it down, making no movements at all in the portfolio. Our second investor, with the benefit of hindsight of course, is only invested during those months that the S&P 500 has an “up month.” So 2008 he was only invested in April, May, August and December as those were the only positive months in 2008. In our view, this is about as “perfect” as any “market timer” would strive to be, and so we feel this pretty well quantifies the best case scenario for market timing. Our last two investors were sector investors, one of which was smart enough to know each and every year what the best performing sector was going to be for the year, and they invested 100% of their portfolio in that sector. The fourth investor was an unfortunate fellow, who was perhaps just following a favorite magazine cover or something else that kept him on the wrong side of things each and every year as he managed to find the worst performing sector each year.

As you might imagine, each of the investors had dramatically different results from their initial investment of $10,000 back in 1993. Mrs. Buy and Hold currently shows a portfolio value of $42,422. Mr. Perfect Market Timer has a portfolio value of $ 1,495,760. Ms. Perfect Sector Timer has seen her portfolio swell to $2,671,726! All while Mr. Poor Sector Timer’s portfolio has now fallen to a lowly $908! Or said another way, the average annualized return for the Buy & Hold strategy since 1993 has been 7.12%, it increases to 26.93% for Perfect Market Timing, and is an astounding 30.49% for the Best Performing Sector. On the flip side, the average annualized return for the Worst Performing Sector portfolio is a -10.80%.