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Learn how relative performance, or RS analysis, can be used over multiple time frames by investors and traders to identify the market’s strongest and weakest sectors.

Sector rotation has been a popular investment strategy for many years. Long-term data on the business cycle gave rise to the idea that certain sectors should do best during certain stages of the economic cycle, so being in the right sector could allow one to beat the market.

The economic cycle was divided into four stages: full recession, early recovery, late recovery, and early recession. Specific sectors were then associated with each stage. For example:

• During the full recession stage, cyclical and transport stocks, along with technology and industrials, were expected to do the best. 

• During the early recovery, the industrials were favored in the beginning, followed later by basic materials and energy.

• During the late recovery, energy stocks should lead early, and then staples, along with the service sectors. 

• For the early recession period, the service and utility stocks were expected to do well early, followed by the cyclicals and transports near the end.

For quite a few of the business cycles of the past 20 years, these have served as useful guidelines.

Of course, the recent recession/depression was much worse than the normal recession. This, combined with the urge to follow the “hot money,” in my opinion, has shortened the time cycles for the sectors. The sluggish nature of the recovery since 2009 has also made it difficult to determine where we are in the economic cycle.

If you can identify a sector when it is just starting to outperform the overall market, and then get out before it becomes a lagging sector, you can dramatically increase your portfolio’s performance.

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For example, in the first quarter of 2011, energy was the top sector. The Select Sector SPDR Energy (XLE) was up 16.8%. Looking at some specific industry groups in the energy sector gave you a further advantage, as the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) was up 22.1% during the same period.

The Percent Change chart above compares the performance of these two ETFs to the Spyder Trust (SPY) starting in October 2011. By the end of the first quarter, XOP was up 51.5%, XLE up 40.8%, and SPY up 16.2%. However, over the next two quarters it was a much different picture, as XLE was down 26.6% and XOP lost 33.5%.

One of the best tools I have found to identify the early stages of sector rotation is relative performance, or RS analysis. This is calculated by comparing the ratio of a sector, ETF, or stock to a benchmark index like the S&P 500. This allows you to determine whether the sector is acting stronger or weaker than the overall market.