Trading Sector Rotation with ETFs

05/24/2012 3:15 pm EST

Focus: ETFs

John Murphy

Head Market Analyst,

Markets shifting to and from risk-on conditions clears the way for new sector ETFs to gain leadership roles, explains John Murphy, and traders can capitalize using a number of popular funds.

We’re talking top sector ETFs with John Murphy. John, with all the sector ETFs out there, for technical traders, where do they look, what do they look at, what do you like these days?

Well, basically there are ten sectors in the stock market. I pay a lot of attention to sector rotations, and that has a lot to do with what the stock market is doing—the interplay between bonds and stocks.

For example, during 2011, one of the clues that we received in the spring of 2011 that the stock market was starting to correct was we noticed, on a relative-strength basis, that money started flowing into defensive stocks, consumer staples (XLP), healthcare (XLV), and utilities (XLU).

Normally, when they assume market leadership, it’s a sign that the market is entering some kind of a correction.

Right, the risk-off phase.

It’s a risk-off trade, exactly. Utilities were the top-performing sector last year; utilities are the worst-performing sector this year.

So now, when things are starting to look a little bit more optimistic, one of the things that we start to see is that those defensive groups land. We start to see money flowing into industrials (XLI), technology (XLK), consumer discretionary (XLY), and stocks tied to commodities. When they’re showing leadership, that’s usually a good sign for the market.

But also, beneath the surface, if you’re positive on the market, it also tells you what sectors you should be investing in.

For example, toward the end of February, energy stocks assumed a leadership role. I think that was tied to the fact that the price of oil was going up; we had the situation in Iran; it was also a sign of global economic strength, and oil prices were breaking out.

Normally when that happens, that means it’s a good time to buy into oil stocks using either the Select Sector SPDR - Energy (XLE) or the Market Vectors Oil Services ETF (OIH). They’re all going up, but it means that energy stocks are beginning to assume market leadership.

And from a trading position, there’s still weakness, even though fundamentally it looks like the story for natural gas, for example, is a long-term story, but it’s not a trading story at this point.

Yeah, natural gas is a whole different story. I’m talking mainly about crude oil, gasoline, and heating oil. They’ve been really surging over the last couple of months. Nat gas has been in a world of its own.

It’s only begun to stabilize a little bit. It’s been in a downtrend for two years now with no real convincing sign of a bottom. But XLE or OIH are good ways to get participation in the broad energy sector.

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