Monday, December 8, 2014

Year End Sector Rotation

With three weeks left in December, it’s time to get serious about one of the major events for asset allocators and that is the annual sector rotation.  2013’s powerhouse sectors like Industrials and Consumer Discretionary broke down at the starting gate and racked up early losses for the year while 2013’s underperformers like Utilities and REIT’s are up nearly twice the S&P 500’s take in 2014.  While for some investors this process is as simple as looking at a Callan table and investing in whoever ranks last, let’s check in on our list of the top behavioral movers to see if we can glean any early indications for what 2015 might have in store for us.

After the strong performance by international markets over the last month, it’s surprising not to have more foreign ETFs on our list.  While James Bullard’s remarks on October 16th about delaying the end of QE in the states may have jump started an international equity rally, Mario Draghi has been adding fuel to the fire with his own commitment to expanding the ECB balance sheet with an asset purchase program potentially in the offing early next year.

Over the trailing month ending 12/5, the SPDR S&P 500 (SPY) has gained 2.8% while the iShares MSCI EMU Index (EZU) has shot past it with a 4.92% gain led by this time by Germany and the Netherlands while more politically unstable France and Italy trail.  With Chairman Draghi’s commitment to taking the Euro behind the woodshed as it falls to levels not seen since 2010, the real winners over the last month were currency hedged ETF’s such as the Wisdom Tree Germany Hedged Equity Fund (DXGE) up over 7.94% and the Deutsche X-trackers MSCI United Kingdom Hedged Equity ETF (DBUK) up 5.38% who made our list at #2 and #22 respectively.

Perhaps the two most surprising funds on the list are the Global X FTSE Greece 20 ETF (GREK) and Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR).  Last Friday’s anticlimactic .86% drop for ASHR capped an incredible weekly gain of 13.83% as the parabolic rally that began in late October on the promise of easier monetary policy restarted the summer rally in Chinese a-shares.  If ranked purely on momentum, ASHR wouldn’t make the list of the top 355 funds (neither would GREK); what really pushes them to the top slots are implied volatility and high short interest.  After such a powerful rally with what John Murphy might describe as a “bump and run formation” it seems a sound strategy to short ASHR at these levels, but with such a large short-interest it’s a matter for debate who’ll be laughing last.  GREK is a slightly different story; with a YTD return of -22.5%, GREK would be close to dead-last among emerging market nations but situated within the Eurozone Monetary Union, Greece might offer a cheaper and higher yielding route to investing in those nations that have the most to gain from a program to expand the ECB balance sheet.

With domestic equity returns being largely driven by growth in earnings rather than in multiples, it’s reasonable to find a number of growth ETFs making the list including the Vanguard Growth ETF (VUG) or those sectors with high cash flows to support future growth such as the Technology Select Sector SPDR Fund (XLK).  What surprised us was the serious drop in healthcare related ETFs on this list.  With nearly twice the 2014 return of SPY, XLV is nowhere to be found in our top 25 while a list that was once dominated by biotech names name only counts 1 among its members with the Market Vectors Biotech ETF (BBH) currently at 25.  Recent momentum has been strong with the sector (using XLV as our benchmark) likely to outperform SPY for the fourth year in a row but that strong performance could be frightening away investors already cautious about the length of this bull market.  Recent drops in short interest and the put/call ratio have pushed down the behavioral score for many healthcare names.

Who has taken their place?  Despite (or perhaps because of) the US dollar’s tremendous performance this year, materials and commodity names have been climbing the rankings.  Whether this is due to expectations for a pullback in the dollar or stronger commodity demand from a resurgent U.S. or China, it’s too soon to say.  And as mid-caps have begun to catch-up to their large and mega cap brethren, the presence of PowerShares Fundamental Pure Mid Growth Portfolio (PXMG) shouldn’t come as a shock to anyone.  But no matter what, 2015 will bring a very different market than the one we’ve enjoyed in this last year.

Thank you for reading ETFG Perspectives!

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