Sector and industry rotation is part of what we do at Pinnacle Advisory Group. When we evaluate sectors and industries there are many things to consider. The business cycle is a place to start and helps to set the framework, but there is much more to the game than just the cycle itself. Investors must consider valuation, technical aspects of the market, earnings, sensitivity to currency movements, political concerns, growth or value tilts, secular headwinds or tailwinds and major risk factors. In short, sector rotating can be very rewarding in a portfolio, but only if you are willing to put in the work to make sure all your bases are being covered.
One technical (non-fundamental) question we ask ourselves when evaluating a sector or industry is, “how crowded is this trade?” In other words, before we allocate capital into an area of the market we like to have a feel for how much institutional money is invested in the sector, which helps us to gauge current market sentiment.
As an example, below is a chart from Ned Davis Research that shows the percentage of investments currently in Healthcare related ETF’s, sector funds, and other sector related assets as a percentage of total domestic sector related assets. As you can see, the percentage of healthcare (indicated by the dashed line) to the total has averaged about 20% since 1990. At the moment the percentage has fallen to 13.3%, which would imply that investors are currently pessimistic regarding this sector. As a sentiment measure, an underinvested sector is typically viewed contrarily as a positive (underinvestment implying better value and less risk). We are aware that this technical measure is blind to structural changes that may be occurring within the healthcare space and that it says nothing about whether the shorter term timing of the investment is appealing (“The market can stay irrational longer than you can stay solvent” – John Maynard Keynes). At present, we would simply interpret this extreme level of underinvestment in the healthcare sector as an on the margin positive that compliments the sectors valuation, strong relative pricing power, and weak dollar sensitivity.
Source: Ned Davis Research
