This sector rotation strategy will help you pick 2019’s winners

 

If you’re looking for the sectors of the stock market set to perform the best in 2019, a good place to start is the sectors that performed the worst in 2018.

That might sound like it flies in the face of rational, reasoned investing. But it’s a strategy that’s produced outstanding results over the past 10 years. Markets and economies move in cycles. And so do sectors within a market – in a way that’s more predictable than you might think.

In 2016, we found that an Asia investment strategy of buying the worst-performing sector of the year at the beginning of the following year – and then holding it for 12 months – resulted in an average annual return that was more than double the return of the index.

We tested the strategy again last year, using the Bloomberg World Asia-Pacific Index, which is made up of over 2,277 stocks listed on stock markets throughout Asia. The strategy suggested that Asia’s utilities sector – the worst-performing sector in 2017, having only a 15 percent return (compared to the index’s return of 28 percent) – would do well in 2018.

The strategy worked. The utilities sector was down 4 percent – which was good enough to be the best-performing sector for the year. (The Bloomberg World Asia-Pacific Index fell 17 percent last year.)

What does the strategy say for 2019?

Avoid a common investment pitfall through rotating sectors

As an investor, it’s easy to follow the herd and buy the stock, or sector, that’s been rising for a long time – because it feels like it’s going to continue to rise. This is called status quo bias, which is when we think that things are going to remain the same – because our most recent memory is of them being a certain way. Investors buy a stock that’s been steadily rising in price because they expect it to continue going up.

Investors expect a bull market to continue because, well, the market has recently been rising.

But markets are like seasons; they move in cycles. They rise and then they fall, and then they do it all again. Just as you wouldn’t buy shorts as autumn approaches (even though everyone else has been buying shorts all summer), you shouldn’t buy into a sector just because it’s been going up for a while.

This is how to rotate your sectors

Sectors of the stock market do better, or worse, each year as their component stocks rise or fall. The chart below shows the performance for each sector of the Bloomberg World Asia-Pacific Index by year.

Each year’s best-performing sector is highlighted in green, while the worst-performing sector is highlighted in red (the overall index’s performance is the first row). So, for example, in 2014, the index rose 11 percent, while the consumer discretionary sector was the market’s worst performer, with a 3 percent decline. The financial sector was the best, with a 27 percent gain.

One thing that’s clear is that the best performers don’t stay on top for long – and there’s a lot of movement between the best- and worst-performing sectors.

Use this sector rotation strategy

We back-tested this strategy for Asia’s stock market sectors: Buy the worst-performing sector of the year at the beginning of the following year (for example, buy the worst-performing sector of 2009 as of the first day of trading of 2010), and hold it for a year. Do the same thing at the beginning of the following year, and so on.

The strategy has worked well from 2007 to 2018. As shown in the graph below, over the past 11 years, it’s outperformed the Bloomberg World Asia-Pacific Index by a huge margin: It generated an average annual return of 6.1 percent, compared to 2.9 percent for the index.

So what does this mean for 2019?

The worst-performing sector in the Bloomberg World Asia Pacific Index in 2018 was the materials sector. It was down 24 percent, compared to the 17 percent decrease in the index.

Does this mean that the materials sector in Asia will perform well this year? Perhaps. History shows that investing in last year’s poorly performing sectors generally makes sense. But if you want to follow this strategy, there aren’t any easy ETFs to use to invest in the sector. However, it’s possible to partly replicate nearly 60 percent of the index “by hand” through the five largest constituents of the materials sector

in the Bloomberg Asia-Pacific Index, as shown below.

Good investing,

Kim Iskyan
Publisher, Stansberry Pacific Research

 

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