Sector Rotation Strategy
Sector rotation is an investment approach that shifts capital between market sectors based on their relative momentum. This guide covers using TradeAnon's rate of change analysis for sector allocation decisions.
Core Philosophy
Sector rotation is based on several principles:
- Leadership rotates — No sector leads forever
- Momentum persists — Strong sectors tend to stay strong
- Economic cycles matter — Different sectors perform in different phases
- Relative performance — Compare sectors to each other and benchmarks
Rate of Change Approach
TradeAnon uses Rate of Change (ROC) to rank sectors and identify leadership.
ROC Calculation
ROC = (Price_today - Price_N_ago) / Price_N_ago × 100
Multiple Timeframes
Analyzing ROC across timeframes provides context:
| Timeframe | Days | Purpose |
|---|---|---|
| 1 Week | 5 | Very short-term |
| 1 Month | 21 | Near-term trend |
| 3 Months | 63 | Intermediate momentum |
| 6 Months | 126 | Medium-term |
| 1 Year | 252 | Long-term |
Ranking Method
- Calculate ROC for each sector ETF
- Rank sectors by ROC (highest to lowest)
- Identify consistent leaders across timeframes
- Note changes in rankings
Sector Selection
Top Performers
Focus on sectors ranking in top 3-4 across multiple timeframes:
Ideal Characteristics:
- Top quartile in 1-month ROC
- Top quartile in 3-month ROC
- Positive ROC across all timeframes
- Rising in rankings (improving momentum)
Avoiding Laggards
Stay away from bottom-ranking sectors:
Warning Signs:
- Bottom quartile across timeframes
- Negative ROC across timeframes
- Falling in rankings (deteriorating momentum)
Relative Strength Confirmation
Beyond ROC, check relative strength vs SPY:
RS = Sector ETF Price / SPY Price
- Rising RS: Outperforming market
- Falling RS: Underperforming market
Implementation
Simple Rotation
Monthly Rebalance:
- Rank sectors by 3-month ROC
- Buy top 3 sectors equally weighted
- Sell sectors that fall out of top 3
- Rebalance monthly
Dual Momentum
Combine absolute and relative momentum:
Absolute Momentum:
- Only buy sectors with positive 12-month ROC
- Avoids sectors in downtrends
Relative Momentum:
- Buy sectors outperforming SPY
- Focuses on relative leaders
Combined Rule:
- Buy if positive absolute momentum AND outperforming SPY
- Move to cash/bonds if no sectors qualify
Tiered Allocation
Weight positions based on conviction:
| Rank | Weight |
|---|---|
| #1 Sector | 30% |
| #2 Sector | 25% |
| #3 Sector | 20% |
| #4 Sector | 15% |
| Cash/Bonds | 10% |
Adjust weights based on overall market conditions.
Economic Cycle Context
Sectors rotate with the economic cycle. While TradeAnon focuses on price-based signals, understanding the economic backdrop adds context.
Early Expansion
After recession bottom:
- Leaders: Financials, Consumer Discretionary
- Laggards: Utilities, Consumer Staples
Mid Cycle
Established expansion:
- Leaders: Technology, Industrials
- Laggards: Defensive sectors
Late Cycle
Peak growth, rising rates:
- Leaders: Energy, Materials
- Laggards: Rate-sensitive sectors
Contraction
Economic weakness:
- Leaders: Utilities, Healthcare, Consumer Staples
- Laggards: Cyclical sectors
Using with ROC
Economic context helps interpret signals:
- Cyclical leadership in expansion is normal
- Defensive leadership may signal caution
- Rotation extremes can indicate cycle transitions
Asset Class Rotation
Extend sector rotation to broader asset classes.
Universe
| Category | ETFs | Purpose |
|---|---|---|
| US Equities | SPY, QQQ, IWM | Core allocation |
| Sectors | XL* series | Tactical rotation |
| International | EFA, EEM | Diversification |
| Bonds | TLT, IEF, HYG | Defense/yield |
| Commodities | GLD, SLV, USO | Inflation hedge |
Cross-Asset Signals
Risk-On Environment:
- Equities > Bonds in ROC
- Small cap > Large cap
- High yield > Investment grade
- Emerging markets showing strength
Risk-Off Environment:
- Bonds > Equities in ROC
- Large cap > Small cap
- Investment grade > High yield
- Gold showing relative strength
Trading Rules
Entry Signals
Buy when:
- Sector enters top quartile in ROC ranking
- Multiple timeframes confirm (1M, 3M both positive)
- Relative strength vs SPY is improving
Exit Signals
Sell when:
- Sector drops out of top quartile
- ROC turns negative across timeframes
- Relative strength vs SPY breaks down
Position Sizing
Base position size on conviction:
Position = Base Size × (1 + Rank Bonus)
Higher-ranked sectors get larger positions.
Rebalancing
Time-Based:
- Monthly rebalance for most investors
- Weekly review for active traders
Threshold-Based:
- Rebalance when sector drops 2+ ranks
- Rebalance when new sector enters top 3
Risk Management
Diversification
Even with rotation, maintain some diversification:
- Minimum 3 sector positions
- Maximum 35% in any single sector
- Consider some defensive exposure
Market Regime
Adjust rotation aggressiveness based on market conditions:
Bull Market:
- More aggressive rotation
- Focus on high-beta leaders
- Fully invested
Bear Market:
- More defensive
- Increase cash/bond allocation
- Focus on relative strength vs absolute returns
Drawdown Limits
Consider reducing exposure when:
- Strategy underperforming benchmark
- Multiple sectors in drawdown
- Broad market weakness
Common Mistakes
Performance Chasing
Don't chase extreme recent performance:
- Extreme ROC can mean reversion coming
- Look for consistency, not spikes
- Consider mean reversion at extremes
Overtrading
Too frequent rotation hurts returns:
- Transaction costs add up
- Taxes on short-term gains
- Monthly or quarterly rebalancing is sufficient
Ignoring Costs
Factor in trading costs:
- ETF expense ratios
- Bid-ask spreads
- Tax implications
Single Timeframe Focus
Don't rely on one timeframe:
- Short-term can be noisy
- Long-term can be lagging
- Use multiple timeframes for confirmation
Performance Expectations
Historical Characteristics
Sector rotation strategies typically show:
- Returns: Market-like to modestly higher
- Volatility: Similar to or slightly higher than market
- Drawdowns: Can be significant in bear markets
- Consistency: Works better in trending markets
When It Works Best
- Clear leadership differentiation
- Trending markets (up or down)
- Sectors moving independently
When It Struggles
- Range-bound, choppy markets
- Rapid reversals
- High correlation (everything moves together)