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Sector Rotation for the Hedged Investor


The Consumer Staples ETF is still a safe place to be -- but don't expect a significant outperformance given the one-year run it's already had.


If you have read our recently released book, Buy and Hedge: The Five Iron Rules for Investing Over the Long Term, then you know that we are strong believers in indexing, and we like to use ETFs to create our index exposure. And as the title clearly states, we invest for the long term. We don't look to time the markets in any way, shape, or form. Our book advocates that around 50% of your portfolio should be invested in broad market indices -- and be hedged.

But that still leaves the other 50% of your portfolio to find targeted investments. And we advocate concentrating some portion of the remaining portfolio in sectors that you think will outperform the broader markets over the horizon. Our horizon is generally one year or more. This approach is often called sector rotation.

Whenever you meet a money manager who uses sector rotation, you'll almost always find that he relies mostly on fundamental analysis or technical analysis when deciding which sectors to concentrate his assets under management. Within our adviser business, we pick the sectors we like and the sectors we want to avoid by using our fundamental analysis; we strictly limit ourselves to the fundamentals and create our long biased sector positions based on the fundamental analysis. But technical analysis does come into play when we decide to exit our sectors. When a sector has a strong run in either direction, we recommend you compare that run to the broader market in determining whether it may have reached its limit or your target price for exit.

Let's look at our current bias. Technology, Consumer Staples, and Energy are the three sectors where we have long biased positions, so we look for solid companies in these sectors. Even if we don't find a specific company that meets our tight value bias, we still create long exposure to the sector using broad-based ETFs while we look for these companies. In particular, the Sector SPDR ETFs have these three sectors covered nicely with Technology (XLK), Energy (XLE), and Consumer Staples (XLP). And these three ETFs all have a robust options market, which makes it easier to hedge them.

Looking at the chart below, these three sectors have done nicely in 2011 year to date, as all have outperformed the S&P 500 (SPY):

But as we study the recent market rally, we see the star performer from this chart is beginning to look a little long-toothed for this rally. The Consumer Staples sector has been up about 8% YTD. But in the recent rally of the last month, Consumer Staples has significantly underperformed all of the other sectors.

If you believe that the recent rally is a bit of a relief rally associated with improved investor sentiment relative to a US economic recovery, then Consumer Staples will almost certainly underperform the broader market going forward. If you think the global and US recovery is still far from certain, then Consumer Staples is still a safe place to be -- but don't expect a significant outperformance given the one-year run it's already had. After all, Consumer Staples usually are lower margin companies with steady revenue profiles. Rarely do they run very high or very fast.

We still like Consumer Staples but would advocate taking a little profit off the table if you have been in the broader sector ETFs. And if you are thinking about putting on a new stock position in Consumer Staples, make sure the investment hypothesis considers the potential for an economic recovery. In fact, we recommended Safeway (SWY) back on October 14 (see How (and When) to Use Sector ETFs to Hedge).

If you put on the Safeway investment back on October 14 at the close price that day, you'd be up 12%. And if you followed our article and put on a sector hedge, that hedge would not have moved much, as the sector is up less than 2% over the same time frame. Few were brave enough to predict the strong move in the broader markets or the Safeway move this fast. Iron Rule No. 5 in our book is to harvest your gains and losses, so we should consider that here.

We still like Safeway and still recommend being long the stock. We expected Safeway to outperform the broader Consumer Staples sector. We just didn't expect it to outperform it in only two weeks by more than 10%. So, since the hedge was built in the sector ETF and that has not moved much in value, we recommend that you remove that hedge and sell it while it still has most of its original value.

Take those funds and reinvest them in a hedge in Safeway directly. Safeway has a liquid options market -- so find a married put option. And think about making the hedge a little tighter than usual, maybe protect your downside a little more than usual. This run-up has been fast and it has coincided with a broader market move. Let's lock in some gains.

Editor's Note: If you're interested in hearing more from Wayne & Jay on ETFs in the future, let us know, and we'll keep you posted on how. But for now, buy their book.

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No positions in stocks mentioned.
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