June 6, 2022: Sector Rotation In A Rising Rate Environment

Jun 7, 2022 | Feature, Newsletter

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Friday July 1, 2022. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Sector Rotation In A Rising Rate Environment

As we stated in the previous newsletter May 9, 2022: The Secular Market Cycle Change, we believe that economy and financial markets are entering a new long term secular cycle that features rising interest rates and high inflation. This would entail a different investment regime that’s different from the one in the past 40 years.

Of course, we also would quickly add that such a secular cycle switch doesn’t happen overnight — it might take a year or two. However, investors should start to be prepared for this. 

In this newsletter, we want to bring our readers’ attention to sector rotation that has begun to do well in the recent market rout and discuss why sector and industry rotation might become more effective in the new environment. 

Recent performance of sector and industry rotation portfolios

First, let’s take a look at the following table:

Portfolio Performance Comparison (as of 6/3/2022):
Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
P Composite Momentum Scoring SP Sector ETFs 19.0% 15.3% 22.4% 15.3% 14.0% 11.0%
P Composite Momentum Scoring Fidelity Select Funds 19.3% 13.9% 28.2% 17.7% 18.8% 16.0%
VFINX (Vanguard 500 Index Investor) -13.3% -0.8% 16.2% 12.8% 14.4% 8.9%

Observations:

  • The Fidelity Select portfolio has been on fire recently.  It also continued its long term outperformance. In fact, since 1996, this portfolio has an annual compound return of 19.5% (click on the portfolio link to see its more detailed performance data), close to most top returns for even best hedge funds (as mutual funds) — we believe in general, a normal non-leveraged stock and bond portfolio’s upper bound annual return is about 20%. 
  • Both sector and industry rotation portfolios have outperformed S&P 500 by 33% year to date, mostly thanks to their exposure to energy, natural resources, materials and utility sectors. 
  • These sectors and industries traditionally do well in a rising rate and high inflation environment, both of which are present. 
  • The sector rotation portfolio lagged behind other portfolios such as style rotation one in the following chart for quite some time in the past. But the picture might start to change in the new environment. 

Discussions

As we have pointed out numerous times in the past, we believe that the general stock (and bond) market indexes such as S&P 500 index will probably deliver some dismal returns for the next decade or two. The main reason is the current highly elevated stock valuation (one of the highest in history, even after the recent decline). Markets will always reverse to their means in a long term. Often, in the mean reversion process, they tend to undershoot to the downside (or overshoot to the upside when starting from a very undervalued position). At any rate, investors should be prepared for negative or close to zero annual returns for the next 10 to 20 years. 

However, in the new secular high interest rate and high inflation environment, hard assets, energy and natural resource stocks usually do well. For example, the following chart compares the returns of a utility mutual fund (FKUTX, Franklin Utility Fund, one of the oldest mutual funds)and S&P 500 index (^GSPC) in the 1980s: 

We can see that utility fund FKUTX didn’t even dip during the stock bear market in 1982 and the black Monday in 1987 while the energy fund FSENX outperformed S&P 500 (^GSPC) by some good margin. 

We want to remind our readers that 1970s and 80s are indeed in some distant memory: in fact, one can only find a handful of mutual funds that dated back in 80s. Only older baby boomers went through this period and now most of them are in their 70s or 80s. So the new investment environment is new to most investors including those who are 50 and 60 years old!

Indeed this is a real game changer for investors. What we have been so used to (such as stocks always go up, indexing will always do well) will probably stumble most of times in the coming decades. 

At any rate, the recent outperformance by energy, utility and natural resources stocks is giving us a good hint that going deeper to various sectors and industries using momentum or trend following strategies would probably be able to cope with low stock market returns. 

Market Overview

At the moment, stocks recovered somewhat. Some claimed that we are already in a bear market and this is a bear market short term rally. Others said we are still in a bull market and it’s still possible that the Federal Reserve will be able to tame inflation while still being able to avoid a recession. We don’t have a strong subjective opinion one way or the other. However, we are closely watching are market internals (not yet uniformly in a downtrend) and a few of key economic indicators, in addition to a general market trend (that has had a negative trend score for a while). We recognize that market fundamentals are definitely weak because of the combination of major events and factors including rising interest rates, high inflation, high valuation (both stocks and bonds), the major war and the pandemic. We want to remind our subscribers that in some extraordinary situations, we might need to rebalance our portfolios intra month, not waiting until the month end. 

We again call for patience and ask investors to stay the course: 

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or preferably much longer given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation has dropped. However, it is still high by historical standard. For the moment, we believe it’s prudent to be extra cautious. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.  

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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