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Chapter 1
Fundamentals of Sector Trading
The most troubling and most common question people ask meââHow can I trade this market?â Uncertainty is the most frequently seen condition, even when some (but not all) of the indicators are strong. No matter what the overall market did yesterday or last month, you really have no way to tell which direction the market will go next.
The problem, though, is that most people judge the market based on index movement. The Dow Jones Industrial Average, NASDAQ, and S&P 500 involve the average movement of many stocks. If half the stocks in the index rise and the other half fall, the net result is a flat (uncertain) market. Using index measurements is not accurate for this reason. Just as you cannot rely on the national averages of housing prices to decide whether the timing is right to invest in real estate, you need to be able to take a closer look at sectors, parts of the market rather than a collective whole. You need a more dependable wayânot only to time your decisions but also to recognize real trends, in real time, to earn real profits. Thatâs where sector trading becomes a valuable strategy; it provides you with the means for focusing in on a segment of the market, identifying a trend, and then acting.
Some people think they can out-perform the averages by following single stocks, but every stock is affected directly by other stocks in their sectors. Remember, a sector is, by definition, a grouping of companies in the same industry, sharing the same competitive and market challenges, and subject to the same supply and demand cycles.
Sector is the name given to a division of the market, a grouping of companies in the same industry, sharing the same or similar market and competitive factors, and subject to the same supply and demand and business cycles.
The selection of one sector over another, based on business trends and current cyclical strength or weakness, is a sensible way to invest. Using the overall market index is not reliable because these are averages of many stocks. Using single stocks is equally unreliable because each stock follows its sector leaders. In addition, single stocks may or may not act according to the larger sector trend, which is why you also need to know how to pick the best stocksâthe leadersâin a sector to ensure that you time decisions properly. In other words, if a sector at large is making a specific move, you need to make sure you pick the right stocks that are leading that trend.
Each sector is defined by characteristics: cyclical business changes, seasonal marketing patterns, and economic trends like interest rates, trade imbalances, and employment. A sector is not just a bunch of companies competing with each other; it is also a grouping of companies subject to the same tendencies, market actions and reactions, and economic and business forces. Sectors can be further broken down into subcategories, and these distinctions are crucial, as I will demonstrate later. The subcategories, may also share distinct and unique models for timing and selection, based on their sub-cycles, sub-economics, and sub-marketing.
My goals in explaining how to trade sectors are to show you how to:
1. Learn how to trade market sectors.
2. Pick specific sectors based on relative strength or weakness.
3. Increase the number of daily trading opportunities.
4. Minimize your risk while maximizing your profits.
All of these goals are realistic and possible, assuming that you are willing to spend the time needed to master the basics and apply sensible rules within a strategic and methodical approach to investing. In this book, I am going to provide you with several important tools in two primary groupings or âlessons.â In the first group, I will focus on skills. Iâm going to show you how to identify the realm of tradable sectors, pick the most effective technical and fundamental indicators, apply sector rotation strategies, make effective use of sector-tracking indices, and analyze risks to pick the right trading exposure for you. This section concludes with my discussion of four keys to sector trading.
In the last group of lessons, I provide you with three strategic methodologies for achieving effective sector trading profits. First is the best knownâthe use of equity positions in companies within specific sectors. You can buy stock (go long) or sell stock (go short). The various methods of approaching these two positions contain specific risk elements. You can also use Exchange Traded Funds, or ETFs, to move in and out of specific sectors. ETFs are traded just like stocks but consist of a bundle of stocks usually within the same sector. Finally, you can also use options to leverage your capital within sectors, involving single stocks, indices, or ETFs.
More on Sector Rotation:
Sector rotation is an investment strategy that was developed out of the economic data from the National Bureau of Economic Research (NBER). The NBER is the reason that we can quantitatively measure each business cycle. Sam Stovall is one of the leading analysts in the field of sector rotation. As chief investment strategist for Standard & Poorâs Corporation, Stovall has an insiderâs perspective on all of the major sectors and industry groups within the stock market. Using that informational base, he performed a number of historical rotation studies, which led to the publication of his now classic book, Sector Investing: How To Buy the Right Stock in the Right Industry at the Right Time (McGraw-Hill, 1996).
According to Stovall (Stone 2005), âThe National Bureau of Economic Research sets dates for peaks and troughs in economic activities, based on its assessment of such factors as gross domestic product and employment growth.â Stovall posits that the process of dividing the NBER cycles into sub-stages will highlight historically successful periods for stocks in unique sectors; this idea is the foundation of sector rotation analysis.
I like to narrow down my guidelines for sector trading into four general areas. These are summarized in Figure 1.1.
Letâs talk about each one of these for a moment.
Follow Institutional Money Flow
The big institutionsâmutual funds, pensions, and insurance companiesâaccount for about two thirds of all daily trading volume, as I wrote in âFollow Institutional Traders â Hereâs Howâ (see www.tradingmarkets.com). You can learn a lot about the market by how institutions act. The first skill I recommend is that you watch how these companies move billions of dollars in and out of specific sectors. Not only do institutional managers trade sectors continuously; because they are so large, their decisions may impact a sectorâs strength or weakness.
This is an important point to remember about institutional traders like mutual funds. They buy and sell in huge blocks of stock in single trades; for the individual, or retail investor, this means that the market and the prices of stock are often determined by the timing of institutional managers. If you observe how institutions trade stocks, you will see a cause and effect in sector performance and pricing. This gives you incredible insight about the market and helps you to better time your decisions.
For Example: If all of a sudden Fidelityâs accumulating huge positions in the retail stocksâat Wal-Mart, Home Depot, Best Buy, The Gapâthen we want to buy those stocks, too. Keep in mind that institutional money flow is going to be what causes a sector to stay strong or a sector to stay weak.
Rotate into Strong Sectors
I encourage you to buy stocks or ETFs in strong sectors. I define a strong sector as one whose potential for price growth is better than average. Later on, I will talk about specific sectors and grouping of sectors that exhibit certain characteristics of strength (or weakness) consistently, based on the same conditions.
Rotate out of Weak Sectors
When people hear my advice to them to rotate out of a sector, they usually think I am suggesting they sell stocks they had previously bought. This is only partially true. You can also initiate a trade by selling short, an alternative way to play the sector market. The attraction of short selling is that it doubles your possibilities for profit. Under traditional buy-hold-sell strategies, you have to buy as the first step, so you are constantly seeking sectors or individual stocks that are oversold and run too high. You then have to wait for prices to fall and accept the possibility that you missed the opportunities. But when you sell short, you reverse the sequence to sell-hold-buy, so you never have to miss an opportunity again. If you start out by identifying a sector that has been run up too high, you can sell short within that sector, wait for prices to fall, and then close the position with a buy order.
Rotating in and out of sectors does not mean selling something you have now and buying something else, although that is certainly one common way to rotate your holdings. It can mean just the opposite. If you are short on a sector, you can rotate by closing your position with a buy order and then either selling or buying a different sector, so rotation is not always replacement. It can also be repositioningâreplacing one long position with another or moving from one short to another. Most people tend to rotate by selling A and buying B, or vice versa. But remember, it can go the other way too. Sector trading, especially using multiple strategies and tools, is both flexible and multi-faceted, helping you identify profit potential in both up and down markets.
Learn Reciprocal Relationships
The term reciprocal usually means âI do something for you and you do something for me.â However, in the context of sector trading, the definition is slightly different. It means that when one sector is strong, another sector is typically weak and vice versa. I suggest seeking out the signs of offsetting, or reciprocal changes, between dissimilar sectors.
The market, at least in the short-term, tends to favor or disfavor specific sectors in turn. Today the market is hot on tech stocks and cold on pharmaceuticals; next week, the whole thing is turned upside down and the market loves drug companies but wants nothing to do with tech stocks. The tendency is to go back and forth among groups, or sectors. This is not always logical, but it does point you to potential profitable timing. This is a reciprocal arrangement; and among the many strategies sector traders use, recogni...
