Granular Sector Analysis: Industry Group Momentum

While broad sector rotation strategies can be effective, a more granular approach that focuses on industry group momentum can provide a significant edge. This article examines into a strategy that goes one level deeper, identifying the strongest industry groups within the leading sectors. This allows for more targeted exposure and the potential for higher returns.

The Edge: Precision and Concentration

The edge of an industry group momentum strategy lies in its precision. Broad sectors are made up of numerous industry groups, and their performance can vary significantly. By focusing on the specific industry groups that are driving a sector's performance, we can concentrate our capital in the most explosive areas of the market.

This strategy is still based on the principle of momentum, but it applies it at a more granular level. This allows us to be more nimble and to rotate into emerging leadership more quickly than a broad sector-based strategy.

Entry Rules

The entry rules involve a two-step process: first identifying the leading sectors, and then drilling down to find the strongest industry groups within those sectors.

1. Identify Leading Sectors: We will use the same relative strength methodology as in our core sector rotation strategy. At the end of each month, we will rank the 11 Sector SPDR ETFs based on their 6-month rate of change (ROC). We will focus on the top 3 ranked sectors.

2. Identify Leading Industry Groups: For each of the top 3 sectors, we will identify the underlying industry groups. A good resource for this is the SPDR sector websites, which provide a breakdown of each ETF's holdings by industry. We will then use a universe of industry group ETFs (e.g., from iShares or other providers) to measure the momentum of these individual groups.

3. Calculate Industry Group Momentum: We will calculate the 3-month ROC for each of the industry group ETFs within our top 3 sectors.

4. Entry Signal: We will buy the top-ranked industry group ETF from each of the top 3 sectors. This gives us a diversified portfolio of three high-momentum industry groups.

Exit Rules

The exit rules are designed to keep us in the strongest trends while managing risk at both the industry group and sector level.

1. Monthly Rebalancing: The portfolio is rebalanced at the end of each month. We will re-evaluate both our sector and industry group rankings. If a sector falls out of the top 3, we will sell the corresponding industry group ETF. If an industry group loses its top rank within its sector, we will rotate into the new leader.

2. Individual Stop Loss: Each position will have a 15% hard stop loss from the entry price.

3. Trailing Stop Loss: A 20% trailing stop loss from the peak price will be used to lock in profits.

Profit Targets

As with our other momentum-based strategies, we do not use fixed profit targets. The goal is to ride the trend in the strongest industry groups for as long as possible. Profits are taken when the momentum wanes, as indicated by our monthly rebalancing or a trailing stop loss.

Risk and Money Management

This more concentrated strategy requires a disciplined approach to risk management.

1. Position Sizing: We will allocate an equal amount of capital to each of the three industry group positions.

2. Sector Diversification: While we are concentrating our capital in specific industry groups, we are still diversified across three different sectors. This helps to mitigate the risk of a single sector-specific event.

3. Drawdown Control: A maximum portfolio drawdown of 20% from the peak equity is recommended. If this level is breached, all positions should be liquidated, and the strategy should be re-evaluated.

A Practical Example

Let's say at the end of August, our top 3 sectors are Technology (XLK), Healthcare (XLV), and Financials (XLF). We then drill down into the industry groups within each sector:

• XLK: Software, Semiconductors, Hardware
• XLV: Pharmaceuticals, Biotech, Medical Devices
• XLF: Banks, Insurance, Capital Markets

We calculate the 3-month ROC for the corresponding industry group ETFs and find that Software (IGV), Biotech (IBB), and Banks (KBE) are the leaders. We would then buy these three ETFs.

This granular approach to sector rotation allows for a more precise and potentially more profitable way to harness the power of momentum. By focusing on the strongest industry groups, we can position ourselves in the true leadership of the market.