Chapter 7-2 Trading Sectors

Many stocks trade in correlation to a sector, industry, or index.  Therefore, it is imperative to understand which stocks belong in which sector.  Always view the price action of stocks in the same sector in order to create a more valid determination on direction.  A move in a stock in the same sector may provide added insight on the stock that you are interested in trading.  Furthermore, many of these more popular sectors have heavily traded indexes that too can provide valuable information.  We recommended using sites like Yahoo! Finance or FINVIZ.com to aid in the sector selection process.

Finding a lager in a sector is a very simple and effective trading setup.  When a stock makes a sharp violent move in a sector, quickly scan through other stocks in that same sector.  Search for a stock that has yet to make a similar sharp move.  Then identify if there is any particular reason why the lagging stock has not yet followed its sector.  In some instances a stock may simply be held back by some large limited size, which when filled can create a sharp and violent breakout similar to that which occurred in its sector, providing a highly profitable trading setup.  Sometimes, however, when too much consolidation has occurred in a stock, the stock will be confined and unable to follow its sector.  Hence, like with all trading setups, one must use a discernable filter in order determine which is the likely outcome.

Below is a small list of some of the more popular sectors along with five of the more highly traded stocks for each of those sectors.  This list should be used simply as a starting point and must be expanded.  Develop your own thorough list of stocks that you feel correspond well together.  Keep in mind, the stocks that you use to create your sector lists should still adhere to your overall guidelines on acceptable volume, price, daily trading range, etc.

Bank

Credit

Insurance

Healthcare

Housing

Steel

Gold

Oil

Gas

Coal

BK

AXP

AFL

AET

KBH

AKS

ABX

BJS

CVX

ACI

PNC

COF

ALL

CI

LEN

NUE

AEM

OXY

HES

ANR

STI

DFS

MET

HUM

MTH

RS

GG

RIG

SUN

BTU

STT

MA

PGR

UNH

PHM

TS

KGC

SLB

VLO

CNX

WFC

V

PRU

WLP

TOL

X

NEM

WFT

XOM

MEE

equities-content-image-7-2-15

Healthcare

On this particular day, the healthcare sector was strong relative to the stock market.  As a result, each stock in the sector rose in price almost in unison.  Each healthcare stock continually made new highs nearly minutes apart, as well as retraced at the same time.

equities-content-image-7-2-3 equities-content-image-7-2-4 equities-content-image-7-2-5 equities-content-image-7-2-6 equities-content-image-7-2-7 equities-content-image-7-2-8

Airlines

equities-content-image-7-2-9 equities-content-image-7-2-10 equities-content-image-7-2-11 equities-content-image-7-2-12 equities-content-image-7-2-13 equities-content-image-7-2-14

Sector Investing and Order Flow

Sectors are market-cap weighted.  This means they give more importance to larger companies.

A sector chart can track returns for:

  • Five days
  • Year-to-date
  • One month
  • Three month
  • One year
  • Three year
  • Five year

When you do this what you see is a very different picture for the various stock sectors.  Some are down sharply over the near past, but better when looking back three to five years.  Other sectors look better in the near past, but show weakness when viewed over longer periods.  The lesson for stock investors is to be thoughtful about what you buy and sell and look at performance as compared to stock sectors as well as total market indexes.

Comparing one stock’s performance to its sector is another way to judge how well or poorly it has been performing.  Stocks that consistently underperform their sector are suspect, while a stock outperforming its sector may be a buy candidate.

Investors usually put sectors into two categories, “defensive” and “cyclical.” Let’s look at these two categories and see what they mean for the individual investor.  Defensive stocks include utilities and consumer staples.  These companies usually don’t suffer as much in a market downturn because people don’t stop using energy or eating.  They provide a balance to portfolios and offer protection in a falling market.  However, for all their safety, defensive stocks usually fail to climb with a rising market for the opposite reasons they provide protection in a falling market: people don’t use significantly more energy or eat more food.  Defensive stocks do exactly what their name implies, assuming they are well run companies.  They give you a cushion for a soft landing in a falling market.  Cyclical stocks, on the other hand, cover everything else and tend to react to a variety of market conditions that can send them up or down; however, when one sector is going up another may be going down.

Here is a list of sectors considered cyclical:

  • Basic Materials
  • Capital Goods
  • Communications
  • Consumer Cyclical
  • Energy
  • Financial
  • Health Care
  • Technology
  • Transportation

Most of these sectors are self-explanatory.  They all involve businesses you can readily identify.  Investors call them cyclical because they tend to move up and down in relation to businesses cycles or other influences.

Basic materials, for example, include those items used in making other goods – lumber, for instance.  When the housing market is active, the stock of lumber companies will tend to rise.  However, high interest rates might put a damper on home building and reduce the demand for lumber.

One of the ways to use sector information is to compare how your stock or a stock you may want to buy, is doing relative to other companies in the same sector.  If all the other stocks are up 11% and your stock is down 8%, you need to find out why.  Likewise, if the numbers are reversed, you need to know why your stock is doing so much better than others in the same sector – maybe its business model has changed and it shouldn’t be in that sector any longer.  You never want to be making investment decisions in a vacuum.  Using sector information, you can see how a stock is doing relative to its peers and that will help you understand whether you have a potential winner or loser.

Using Sector Order Flow

Investors rebalance their portfolios as their views about expected returns and risk change.  We recommend you use empirical measures of portfolio rebalancing to back out investors’ views, specifically views about the state of the economy.  We show that aggregate portfolio rebalancing across sectors is consistent with sector rotation, an investment strategy that exploits perceived differences in the relative performance of sectors at different stages of the business cycle.  The empirical foot-print of sector rotation has predictive power for the evolution of the economy, future stock market returns, and future bond market returns, even after controlling for relative sector returns.  Contrary to many theories of price formation, trading activity therefore contains information that is not entirely revealed by resulting relative price changes.

It is well documented that asset prices and returns help forecast business cycles.  The motivation of this literature is that the information about the current and future states of the economy collected and processed by investors is revealed by the (change in) relative prices of the securities these agents trade in response to this new information.  Asset prices are therefore a leading and often thought of as sufficient statistic for the information, whether public or private, available to agents.  Order flow, the act of buying or selling securities, is the conduit through which information about economic fundamentals are aggregated into asset prices.

Combining these two observations, that asset prices help forecast business cycles and that order flow is the mechanism by which asset prices change, raises the question of how order flow itself is related to current and future economic conditions.

Does order flow forecast the Rate of the economy by itself and in conjunction with asset prices? To the extent that order flow has (marginal) predictive power, what is the exact nature of this information?

It is conceivable that order flow may contain more or different information than is contained in prices or returns.  We focus our analysis on sector rotation, a highly publicized investment strategy that exploits perceived differences in the relative performance of sectors at different stages of the business cycle.  With regard to order flow predictability, our experiences show that market participants shift funds between equity sectors according to their collective information about changes in the macro economy as much as three months ahead.  Consistent with economic intuition, large-sized active order flow into the material sector forecasts an expanding economy, while large-sized active order flow into consumer discretionary, financials, and telecommunications forecasts a contracting economy.

While the percentage of order flow across years remains fairly stable, there are some extreme percentages during the economic downturn in 2008 and 2009.  Materials and consumer staples have low fractions of order flow while health care, information technology and telecommunications have high fractions of overall order flow.

In addition, these shifts in the shares of order flow across sectors appear more pronounced for large orders relative to all orders, suggesting that market participants placing large orders may be more aggressive and/or savvy in positioning their portfolio ahead of changes in the economy.  Therefore, we supplement the equity sector order flow with information about the current state of the economy, including stock and bond performance.  Under the simple assumption that large orders are more likely to originate from institutional investors, while small and medium orders are more likely to originate from retail investors, we believe that institutional investors are better able to position their trades in anticipation of changes in the economy than are retail investors.

Conclusion

In summary, it is clear that the link between aggregate sector order flow and the macro economy is strong, with large-sized active order flow in specific sectors able to forecast expansions/contractions up to one quarter ahead.  A large net order flow in one sector could be the result of investors increasing the weight of that sector in their portfolios or it could also be the result of a heavily traded single stock within the sector for reasons unrelated to expected economic conditions (for instance, stock picking based on private information).  The predictive power should be stronger whenever order flow within one sector is more homogeneous across stocks in that sector.  For example, order flows into, consumer discretionary and staples, health care, financials and utilities are all negatively related to economic expansion, which suggests that a negative excess return in these sectors predicts an expansionary economy.  In contrast, flows into the materials sector and flows out of the financial and utility sectors are associated with an expanding economy.

Questions