From David Fabian: Every year brings with it new challenges with respect to sector leaders and laggards. This is particularly acute for investors that own individual stocks or that like to add tactical exposure via sector-focused ETFs. Sometimes you are in the sweet spot and other times you miss the mark entirely.
That scenario perfectly encapsulates the recent divergence between the top and bottom performing sectors this year. Technology has been the big outperforming growth theme that has been driven by tremendous momentum and enthusiastic sentiment. Conversely, energy stocks have languished by the wayside as falling oil and natural gas prices weigh on valuation prospects.
Investors are going to interpret these themes in two varying ways. One camp is going to be firmly entrenched in the notion that you ride momentum in the top performing area of the market for as long as you possibly can. Strong stocks often stay that way for much longer than people expect them to.
The flip side is the fear that the stock price appreciation is unsustainable given the size of the move to-date. This perspective aligns with the notion that stepping out of one high-priced area of the market and potentially looking to step into another area with better relative value may be an attractive rotation opportunity. That’s where the bullish camp for energy may ultimately reside despite the bleak prospects of the current trend.
Ultimately, the timing of this switch may come down to simple technical analysis. Examining individual charts of both sectors, it’s easy to see that even with the two-day drop, XLK has been able to maintain its positioning above the 50-day moving average (smooth blue line).
Similarly, XLE has been unable to generate sustainable momentum to break above this same intermediate-term trend line. A surging move above the 50-day simple moving average may ultimately mark the start of positive divergence characteristics for energy stocks relative to the rest of the market.
For investors that are considering a switch of this nature, it may behoove you to wait for either of these events to occur prior to simply making a top or bottom call on a random day. That way you have evidential price movement to endorse the fundamental rotation strategy rather than simply trading it on gut-feeling alone.
There is always the chance of a whipsaw (failed signal and reversal) in both instances. However, the consideration of technical strength or weakness can often predict key turning points in the market. These signals are particularly important for investors that find themselves now overweight a tech or consumer discretionary stocks due to the price appreciation and underweight other value-oriented sectors.
The Bottom Line
Sector rotation doesn’t have to be an all-or-nothing proposition. These steps can be accomplished in incremental adjustments as a function of sound trading discipline. Thinking in terms of lightening up on your exposure in one area and adding to another may help improve your diversification and ultimately your long-term returns.
The Energy Select Sector SPDR ETF (NYSE:XLE) fell $0.17 (-0.26%) in premarket trading Friday. Year-to-date, XLE has declined -12.81%, versus a 9.05% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of FMD Capital.