Sector Rotation For Self-Directed Portfolio Management: Narrowing Focus Using Free, Open-Source, Tools To Spot Trends & Reduce Risk
Note: This article was researched using a free and open-source financial research terminal, available to anyone (MacOS/Windows/Linux) on GitHub: https://github.com/GamestonkTerminal/GamestonkTerminal/
NFA — for information purposes only. The author has no positions in any security mentioned and this article should not be construed as a recommendation to buy or sell any specific investment.
Lately there has been a lot of chatter around the subject of sector rotation. A broad narrative cut with a combination of fear and/or greed, very loosely defined as moving capital from one slice of pie to another. Reduce weighting here, increase allocations there. It’s like changing wardrobes every season, except for commodities and equities; and this ain’t grandpa’s telegram company no more.
Themes packing the narrative fudge this year have sour notes to them, showered with heavy doses of hot inflation prints, and are lumped together with a brand-new struggle to simply keep the heat on this winter.
For the time being, fear>greed and, little Billy couldn’t get a lump of coal for Christmas because ESG policies prohibited Santa’s reckless use of the dirtiest fossil fuel burning today. Despite whatever rumours are spreading about the pending delivery schedule, this will have an impact on Santa’s audited GAAP statements going forward.
New factors of government and regulatory agency risk are likely to have negative impacts on entire regions in the near future; and without offsetting carbon emissions, there will be no flights. To make matters even worse in the short term, Santa has been dealing with an entitled and overpaid workforce too lazy to show up at their seasonal part-time cash job in a much cooler working environment than that cushy union gig at the Willa Wonka campus.
It is a perfect storm for the North Pole where costs have skyrocketed, suppliers are short, and insurance premiums are through the roof. Margins thinner than a housewife on diet pills in the 80s (less volume, more costs), energy costs burning hotter than the new series coal-powered electricity plants in China, and animal rights activists grinding Santa’s delivery fleet to a near halt has everyone up north short on heat and taking free haircuts this winter.
https://www.forbes.com/advisor/investing/what-is-sector-rotation/
There are standardized classification systems used around the world, some more colloquial than others, with variance in names and quantities of top-level categories as well as the breakdown over subcategories and industries. The various databases have evolved into the core business of index investing with every major provider transitioning to their own proprietary classification system. While likely to change in subtle ways, the Terminal currently recognizes sectors as listed here:
- Basic Materials
- Communication Services
- Consumer Cyclical
- Consumer Defensive
- Energy
- Financial Services
- Healthcare
- Industrials
- Real Estate
- Technology
- Utilities
Find this list by navigating to the Sector and Industry Analysis submenu contained in the Stocks Menu.
- Launch the terminal.
- Without the quotes, “/stocks/sia/”, brings you directly to the Sector and Industry Analysis Menu.
To see the list of countries available, enter the command “country”.
“cpcs” displays the proportional size of a sector on the global scale, below is the distribution of large cap companies in the utilities sector.
The global trend across sectors has devolved into a yelling contest for virtue signalling. The echoing chorus gives way and a call-to-action brings the forecasted trend to life. There are several ways to spot trends using the Terminal, micro and macro. Behavioural analysis is one tool available to micro economists. Buzzwords are the sprouting seeds of trends, harvested as they mature across the fields of social media. Nurtured incubation encourages virility as a trending hashtag that becomes a talking point. Sometimes, things are only a joke and should be treated as one. Separate the hype from the hash by doing the research. KYC — Know Your Company. The incubators of tomorrow are rapidly evolving so it pays to keep up with what those damn Gen-Z folks are up to now.
trending (stocks/ba/trending) shows the most active tickers on StockTwits, a popular message board for day traders and stock promoters. The daily sentiment represents a skew in tickers which can be interpreted, alongside the traditional media talking points that are developing, with fundamental analysis to form an educated opinion on thematic market narratives.
cnews (stocks/disc/cnews) aggregates news links using categories to filter articles.
Common themes sprout up in social media feeds over weeks and months that give rise to directional clues that are verified in hindsight through print media. Listen to what the people in charge say, in audio and print. Portfolio managers will announce their agendas publicly, portraying their view on how the evolving market sentiment determines the sector weighting their fund is balancing for. Changing behavioural patterns will raise the flag for investigating the presence of a signal, an indicator. Sector rotation itself will change as it passes through the stages of the business cycle. According to Fidelity, there are four distinct phases of a traditional business cycle:
- Early-cycle phase: Generally, a sharp recovery from recession, marked by an inflection from negative to positive growth in economic activity (e.g., gross domestic product, industrial production), then an accelerating growth rate. Credit conditions stop tightening amid easy monetary policy, creating a healthy environment for rapid profit margin expansion and profit growth. Business inventories are low, while sales growth improves significantly.
- Mid-cycle phase: Typically, the longest phase of the business cycle, the mid-cycle is characterized by a positive but more moderate rate of growth than that experienced during the early-cycle phase. Economic activity gathers momentum, credit growth becomes strong, and profitability is healthy against an accommodative — though increasingly neutral — monetary policy backdrop. Inventories and sales grow, reaching equilibrium relative to each other.
- Late-cycle phase: This phase is emblematic of an “overheated” economy poised to slip into recession and hindered by above-trend rates of inflation. Economic growth rates slow to “stall speed” against a backdrop of restrictive monetary policy, tightening credit availability, and deteriorating corporate profit margins. Inventories tend to build unexpectedly as sales growth declines.
- Recession phase: Features a contraction in economic activity. Corporate profits decline and credit is scarce for all economic factors. Monetary policy becomes more accommodative, and inventories gradually fall despite low sales levels, setting up for the next recovery.
Judging by the recent news events, expanding volatility across markets, and the rising level of uncertainty that has knocked back investor sentiment, high-valuation stocks have fallen out of favour. Fund mangers took risk off the table to enter bonus season, and the reallocation of capital flows cautiously in to more boring — stable and liquid — assets, keeping larger amounts of cash on hand for adjusting tax liabilities and early year capital deployment strategies. Don’t burn up all that dry pow before you get to the party. Save it for when the party is dying of late-night exhaustion and would kill for a bump to get through the next day.
Using the business cycle to consider sectors of the economy, a late-cycle phase will transition away from hyper-growth assets fundamentally over-valued and regarded as speculative. Companies with a long history of increasing quarterly dividends, so-called blue-chips, are seen as “safer” because of the historically predictable nature of recurring revenue. Commodity-based energy utilities will have more external market forces than renewables. Environmental risk created by natural disasters and climate change (human-intervention or not) sow the seeds for industry F.U.D. from NGOs and the carbon-free movement. Compounding derivatives of risk play out where the political narrative becomes indistinguishable from the corporate or capitalist version. Where there is exposure, external market forces have more gravity on the microeconomics of a single corporation than their ability to pivot during a rapidly changing macroeconomic environment.
Although technology can reduce personal energy consumption through improvements to efficiency it will, at best, only slow the growth of demand from a growing population and connected infrastructure. It is inevitable that there will always be an urgent need for consistent and reliable energy, but the future source of energy will play a growing factor in the price that a market is willing to pay.
The term “clean energy” (more Orwellian by the day) continues to get traction as a hot buzzword in the new year. Expect narratives to form around the growing sub-sectors and industries tasked with replacing decrepit and toxic infrastructure. Sceptics will label most actions short of true innovation as greenwashing, and they will be mostly justified, but sweeping industry narratives rarely get in the way of a solid investment. With an acute sense of awareness for the macro begin to zoom in on the micro. Take the blinders off and narrow the field of vision.
The Terminal can display recent performance data for sectors and industries as sortable columns. /economy/performance -h, will present the output below describing the optional arguments available for this feature.
The word on the street has been: energy; and, really everything that captures revenue from basic cost-of-living expenses. Energy prices are skyrocketing, and the supply of heat energy is being brutalized by political sanctions passing around the global hot potato.
The energy sector in the USA is by far the largest player at the global level; however, scaling at the national level reveals energy is not the most important factor in arguably the largest economy in the world. This follows logic because, when the economy does not rely on the churn of commodity energy output, there is more diversity.
In the Sector and Industry Analysis Menu, “cps” will breakdown the distribution of large cap companies across sectors in the USA.
“cpis” will zero in on the industry weighting by sector.
Repeating the exercise reveals a correlation factor that does not jive with the narratives shaping the future. For now, clean energy is not a factor in the American large cap energy sector.
During this phase of the business cycle, new allocations are more likely to go towards the utilities sector than the energy sector. Many, regulated, electric, large cap, utility companies fall under the industry catch-phrase, renewable. Demand for electricity only rises even with companies improving efficiency in the creation, storage, distribution, and consumption of electricity. Regulators are now forcing industry allocations within sectors, allowing for the preferential treatment of companies meeting the clean and/or renewable energy labels established by trade associations masquerading as quasi-government agencies.
ESG is the hot new acronym crossing over from the energy sector that is bullying G20 nations to adopt policies blindly, shown only to work on paper. The titans of energy will bend the rules and pay the vig. Carbon markets affords the polluters an opportunity to “off-set” their emissions, granting them “carbon neutral” status. With an approved label, large institutional divestment can be avoided and the cost of compliance becomes a hidden tax on the consumer. The problem is never actually solved, only taxed.
With a fair amount of certainty, utility and energy companies exposed to the least amount of regulatory/government agency risk are the zero-carbon solutions. Recently established companies integrating technology-based solutions within the broad-strokes industry of clean energy are more likely to see long-term compounding growth when compared to legacy utilities still set in their ways, saddled with infrastructure liabilities.
Consider the type and objectives of the investment while narrowing focus within the sector and industry. Some questions to mull over include:
- What is the amount and intended duration for the investment?
- Does this expose you to a suitable level of risk for the return profile being sought?
- Is a hedging strategy required?
- Will there be a covered call strategy?
- Is it important for the company to pay a dividend?
- Is there correlation across your portfolio to this industry already?
- How actively will the position be managed?
The answer to these questions will filter the companies down to a short list of candidates. In the Sector Analysis Menu, comparative bar graphs show the researcher visual representations of fundamental metrics.
“metric mc” will show the ten largest companies in the regulated-electric industry, of which NextEra Energy is the industry giant.
NextEra may have the largest market cap in the industry, but the book value of the company is not in top ten rankings. Duke Energy Corporation has the second highest market cap and the highest per-share book value.
To put things into perspective, the number of outstanding shares needs to be considered. “metric fs” will order the industry by the share float amount. As suspected, NextEra Energy also has the largest float, which dilutes the earnings per share number and can distort the perception of fundamentals when comparing with other companies. For example, if company A has earnings-per-share of $10 and only $5 by Company B, but, Company B has twice the number of outstanding shares, then the total earnings are the same.
Ranking the industry according to their debt/equity ratio will provide insight into the general condition of the balance sheets. Duke Energy and NextEra Energy both have debt levels well below the industry benchmark.
Comparing the EBITDA levels, Duke Energy shows strong industry performance with 50% more earnings while being valued at about half of the NextEra’s market cap.
Having a look at free cashflow numbers puts Dominion on the radar. The level of free cashflow is a potential signal that a corporate action may be coming; a clue to scour the rumour mills with.
Revenue growth is a great way to visualize the relative performance of a company versus its competitors. Within the industry, FirstEnergy Corp has the most debt, but is also struggling to grow revenue along with Duke Energy. Legacy utility companies do not have the agility to pivot their business and can find themselves trapped in a downward spiral of deprecating infrastructure expenses.
“…Less than two weeks after emerging from an 18-month bankruptcy caused by its multibillion-dollar wildfire liabilities, Pacific Gas & Electric faces yet another lawsuit for a 2019 fire that California investigators say was caused by its power lines.
On Thursday, the state’s Department of Forestry and Fire Protection confirmed that the Oct. 2019 Kincade fire was caused by a failure of a PG&E transmission line in Sonoma County. The fire burned 77,758 acres, destroyed 374 structures and forced the evacuation of about 190,000 people, though no one was killed in the blaze.
PG&E had already conceded that a failed jumper cable on a transmission line was the likely cause of the fire and has set aside $600 million in anticipation of covering resulting damages — a figure at “the lower end of the range” of potential losses, the utility stated in its first-quarter earnings report.”
NYSE:PCG will be the subject of endless litigation hearings carrying the ever-looming risk of insolvency. Their current predicament is entirely the result of poor judgement and execution of long-term fiscal responsibility that comes with owning critical electrical utility infrastructure. It is no surprise to the short interest on PCG is by far the highest out of any company in the industry.
The disaster, having long-lasting ramifications, was caused by neglecting failing components in its electrical grid. When these types of disasters occurn government inquiries reveal, without surprise, that decisions made by executives and board members — the ones standing to most benefit from reduced net spending at the enterprise level — are almost entirely responsible for the failures of components beyond their expected life cycle, and for breeding the corporate culture that permitted the flagrant safety violations under the ruse of slashing budgets. With that in mind, it would be wise to scratch them from the list. If you are buying PG&E, hopefully you get a good price on the whole lot at a bailiff’s sale.
Future earnings expectations will show the degree of expectations already baked in to the share price. When things do not go according to the forward guidance set by the company, a multiples compression event can happen. Strong dividend stocks will generally have lower price multiples because a larger portion of the profits are extracted from the stock price every distribution. Dividends can bring more stability to the share price; however, legacy corporations can be infiltrated by powerful board members to apply pressure on the company to keep delivering larger dividends every quarter, despite a weakening financial outlook and nearly everything requiring upgrades yesterday.
Like in food, salt makes everything better. Curing financial opinions and data in a vat of salt will sterilize the signal, neutralizing bias. Collect information indiscriminately to form your narrative. The numbers won’t have an opinion; but, there should be many well-informed assholes with plenty to say.
Fundamental metrics available to this feature are shown below.
Understanding who stands where in the industry using basic fundamentals will put context to what analysts are saying.
With a short list of companies to work from, the next logical steps would be to inspect the correlation and price movements of candidates and determine which stocks, if any, meet the full criteria for investment that was determined by the desired strategy. The Terminal can automatically import the stocks just compared to the Comparison Analysis menu. The command, “ca”, will jump menus.
A correlation heatmap should help distinguish the individual price action from the industry.
Thanks for reading, and if you know someone who could benefit from this information, please share. Next, we’ll look at how these same research strategies can be applied to broader baskets of sector-weighted ETFs.
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