I. Introduction
I think the hardest part about trading is that the market is constantly evolving. We are creatures of habit, as a result we get complacent and think we can find a single, comfortable strategy that works an infinite amount of times. This is almost never the case; different market conditions call for different approaches. By combining this post with my last, you should obtain a basic understanding of how you can read market conditions, and adapt with the market.
If you read my previous post, you now know when money is flowing into equities, and when it is flowing into bonds, the dollar and other safe havens. You also know about the different indexes, and what basket of stocks they carry. You even know about some interesting correlations that have arisen recently related to tech and a risk off rotation.
In this one - I'm going to take it a step further, and dig a little deeper, showing you all how to tell exactly which types equities money is flowing to, and how to use that to generate high probability trades. In this era of passive indexation, you are almost never just buying one stock. You are buying one stock - and every stock correlated to it.
To avoid this phenomenon - you need to understand the different different sectors present within the market. Equities all belong to at least one of these - and will usually track the rest of the stocks within their respective sectors quite closely.
II. The Eleven Sectors That Define The Market
There is generally believed to be eleven different sectors that equities belong to. In this section, I'll detail what each one is, the ETF you can use to track it, and what environment it usually outperforms in.
Also, there's two main categories for stocks: cyclicals - which follow the business cycle, and non-cyclicals - which perform the same year round.
1 - Energy (VDE)
What It Is -
"The energy sector is a category of stocks that relate to producing or supplying energy. The energy sector or industry includes companies involved in the exploration and development of oil or gas reserves, oil and gas drilling, and refining. The energy industry also includes integrated power utility companies such as renewable energy and coal."
- Investopedia
Basically, this sector is dominated by the oil industry. You will notice renewables will hardly effect it's price movements a vast majority of the time. While many are trying to shift away from oil, it will likely be a massive part of our economy and our market long into the future.
When It Outperforms -
In most situations - the energy sector is cyclical. This means when our economy is doing well and expanding - it will perform well. When it isn't, the reverse is true. Because it is dominated by a commodity, energy companies also have no issue passing on inflation to their consumers. However, keep in mind this one is a bit special because of OPEC and their ability to influence price.
"OPEC is a cartel that aims to manage the supply of oil in an effort to set the price of oil on the world market, in order to avoid fluctuations that might affect the economies of both producing and purchasing countries."
- Investopedia
Basically, they have most of the oil, and fix the prices to their liking. This can have some unforeseen effects on the market, so if you are trading energy you definitely want to monitor their movements.
2 - Materials (VAW)
What It Is -
"The basic materials sector is an industry category made up of businesses engaged in the discovery, development, and processing of raw materials. The sector includes companies engaged in mining and metal refining, chemical products, and forestry products."
- Investopedia
When It Outperforms -
The materials sector is cyclical. It is sensitive to changes in the economy and tracks it pretty closely. This is another sector that can easily pass inflation onto their consumers due to the nature of their products. It's also going to be especially sensitive to any changes in the supply and demand of raw materials worldwide.
3 - Industrials (VIS)
What It Is -
"The industrial goods sector includes stocks of companies that mainly produce capital goods used in manufacturing, resource extraction, and construction. Businesses in the industrial goods sector make and sell machinery, equipment, and supplies that are used to produce other goods rather than sold directly to consumers."
- Investopedia
Basically, the materials sector passes raw materials to the industrials sector - which converts them to products used to manufacture the final products passed on to consumers.
When It Outperforms -
Because it is so closely tied to how much companies are producing - this sector is also cyclical. This is yet another sector that can pass the costs of inflation onto their consumers. Subsequently, due to it's close ties with the materials sector - it will be especially sensitive to the supply and demand of raw materials.
4 - Consumer Discretionary (VCR)
What It Is -
"Consumer discretionary is a term for classifying goods and services that are considered non-essential by consumers, but desirable if their available income is sufficient to purchase them. Examples of consumer discretionary products can include durable goods, high-end apparel, entertainment, leisure activities, and automobiles."
- Investopedia
Essentially, anything broke people can't afford, like those who went all in on WISH calls before earnings, goes in this basket.
When It Outperforms -
Because it depends on the income of consumers - this is also a cyclical sector. When the economy is thriving, people will have more money to blow on non-essential goods, like $120 Lululemon shorts, or tickets to Disney World.
5 - Consumer Staples (VDC)
What It Is -
"The term consumer staples refers to a set of essential products used by consumers. This category includes things like foods and beverages, household goods, and hygiene products as well as alcohol and tobacco. These goods are those products that people are unable—or unwilling—to cut out of their budgets regardless of their financial situation."
- Investopedia
Basically the opposite of consumer discretionary - these are things people NEED not things that they WANT.
When It Outperforms -
These are non-cyclical, or defensive - which means regardless of how the economy is doing they will perform more or less the same. This means when the economy is taking a turn for the worst, they will generally outperform the other sectors. This doesn't mean they are immune to business cycle changes entirely, but they are certainly much less affected by them.
6 - Health Care (VHT)
What It Is -
"The healthcare sector consists of businesses that provide medical services, manufacture medical equipment or drugs, provide medical insurance, or otherwise facilitate the provision of healthcare to patients. The healthcare sector is one of the largest and most complex in the U.S. economy, accounting for close to a fifth of overall gross domestic product (GDP). The U.S. healthcare sector benefits from a strong system of medical research and development, in cooperation with the higher education system and the technology industry. The aging U.S. population and the advancing senescence of the Baby Boomer generation are driving ongoing strong demand in the healthcare sector."
- Investopedia
When It Outperforms -
This one is a bit complicated because there are a few industries within the sector, namely: medical equipment, drug R&D, and health insurance. The sector is non-cyclical - but each industry has it's own quirks.
The drug industry in particular often moves independently of everything else on the market, because it is highly dependent on new developments and news pieces related to potentially groundbreaking treatments. Health insurance and medical equipment is usually non-negotiable regardless of the business cycle - so it will outperform in times of economic distress, and generally perform the same year round.
7 - Financials (VFH)
What It Is -
"The financial sector is a section of the economy made up of firms and institutions that provide financial services to commercial and retail customers. This sector comprises a broad range of industries including banks, investment companies, insurance companies, and real estate firms."
- Investopedia
When It Outperforms -
Banks involve the supply and demand of money. They make money through fees and interest rate spreads. Banks perform well during economic expansion when companies and individuals are borrowing money. One of the main drivers of borrowing/lending is interest rates. In a rising rate environment (observed through TNX, TLT, US treasury yield curve), banks will outperform. They pay short term rates (front of curve) on their deposits, and lend money to companies or individuals at a higher interest rate (further out on the curve) capturing a difference or "spread" on interest paid vs received. Understanding treasury yields and how they are related to the daily price movements in the financial sector is a great place to start.
8 - Information Technology (VGT)
What It Is -
"The technology sector is the category of stocks relating to the research, development, or distribution of technologically based goods and services. This sector contains businesses revolving around the manufacturing of electronics, creation of software, computers, or products and services relating to information technology."
- Investopedia
This one really needs no introduction.
When It Outperforms -
This is a bit tricky due to some correlations that have arisen from 2020 onward. For most of history - most tech stocks were cyclical. However, due to COVID, extremely low interest rates, and some other factors - these assets are now being rotated into during a risk off environment - and are seen as a safe-haven. Who knows if this will stand, but it's important to understanding when money will flow there today. More on this can be found in my previous post, where I go into detail on this phenomenon.
9 - Communication Services (VOX)
What It Is -
"The telecommunication sector is made up of companies that make communication possible on a global scale, whether it is through the phone or the Internet, through airwaves or cables, through wires or wirelessly. These companies created the infrastructure that allows data in words, voice, audio, or video to be sent anywhere in the world. The largest companies in the sector are telephone (both wired and wireless) operators, satellite companies, cable companies, and Internet service providers."
- Investopedia
When It Outperforms -
This is another non-cyclical sector. Whether the economy is good or bad - people aren't going to give up communicating with each other. In today's world, everyone needs a phone - even if it's a flip phone - and everyone needs internet access. One of the interesting parts of this sectors is that it is comprised of both growth names and income names. While the larger names are more consistent with dividends, the smaller names often have more room for capital appreciation and earnings growth.
10 - Utilities (VPU)
What It Is -
"The utilities sector refers to a category of companies that provide basic amenities, such as water, sewage services, electricity, dams, and natural gas. It is a large sector, and an important part of the U.S. economy, with a market capitalization of over $1.5 trillion (as of March 2021). Although utilities are private, for-profit companies, they are part of the public service landscape—providing as they do such staples for daily living—and are therefore heavily regulated. Investors typically treat utilities as long-term holdings and use them to generate a steady income for their portfolios."
- Investopedia
When It Outperforms -
Yet another non-cyclical basket of stocks. Regardless of the business cycle, demand for utilities almost always remains constant. These are some of the most stable stocks on the market - so WSB is probably better going to forget they exist moments after reading this post.
11 - Real Estate (VNQ)
What It Is -
"Real estate is the land along with any permanent improvements attached to the land, whether natural or man-made—including water, trees, minerals, buildings, homes, fences, and bridges. Real estate is a form of real property. It differs from personal property, which are things not permanently attached to the land, such as vehicles, boats, jewelry, furniture, and farm equipment."
- Investopedia
When It Outperforms -
Like most industries, real estate involves the supply and demand of property, both residential and commercial. Real Estate is closely related to changes in construction or development, but also heavily influenced by interest rates. Most participants are using Loan to Value (LTV), anywhere from 60-85% of the total property value; therefore, interest rate changes will impact participants' ability to borrow. Thinking through these variables, its safe to assume that real estate performs well in low interest rate environments, low-moderate commodity prices for construction, population growth, and government (both local and federal) infrastructure support. When rates rise, the debt burden increases and money is hard to borrow; which ultimately affect the ability to invest in new projects or purchase homes.
III. Practical Applications
To use all of this information - and convert it to probabilities I can use to trade - I perform technical analysis on each sector ETF using the 1 year 1 day chart (swing trade timeframe). If one is breaking out of a large setup - I can assume money is going to move there in the future. If others are forming nice setups - I know to add them to my watchlist.
After identifying a sector that is likely to become strong in the near future - I then filter it further by finding particular stocks within the sector that have similar setups. I usually look through the top holdings of the ETF pertaining to the sector. I do this because individual stocks are more volatile than sector ETFs and more liquid - which means there is more money to be made. If a particular stock is lagging behind the sector, it can also mean there is even more to gain than in the case of another name.
You can take this one step further and combine information from my previous posts by identifying whether we are risk on, or risk off. Cyclicals are generally going to outperform while we are risk on. Non-cyclicals will generally outperform while we are risk off.
Example -
Last week - I noticed financials were breaking out of a large falling wedge on the daily chart. This has a bullish bias - and indicates price will make a strong move in the near future. I didn't have to scan the ETF for this one, since all the stocks in it are household names.
VFH (Financials) 1 Year 1 Day
I also noticed BAC had formed a bull flag. This was all the information I needed to enter some October Calls which I closed today for a nice profit.
BAC (Financials) 1 Year 1 Day
Lastly, ZB was trending downwards and yields were rising. This was an environment banks outperform - which means it enforced my probability of success even more.
ZB (Bonds) 1 Year 1 Day
You don't have to use technical analysis. This is just my preference. Many people use complex fundamental and economic analysis to determine these rotations. The important thing is understanding the environments particular sectors will outperform in.
V. TL;DR
There's 11 sectors within the stock market.
They are:
- Energy (VDE, Cyclical)
- Materials (VAW, Cyclical)
- Industrials (VIS, Cyclical)
- Consumer Discretionary (VCR, Cyclical)
- Consumer Staples (VDC, Non-Cyclical)
- Healthcare (VHT, Non-Cyclical)
- Financials (VFH, Cyclical)
- Information Technology (VGT, Cyclical Most Of The Time)
- Communication Services (VOX, Non-Cyclical)
- Utilities (VPU, Non-Cyclical)
- Real Estate (VNQ, Cyclical)
Each one will be rotated into depending on different market conditions. Understanding this is important to being able to make money at any given time. I perform technical analysis to determine when each is being rotated into, but you can use any analysis you want.
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