Sector Trading Strategy (Backtests And Examples)

Last Updated on August 5, 2022 by Oddmund Groette

The S&P 500 Index is categorized into 11 sectors, and investors try to profit from the various sectors. One brilliantly simple way to profit from the market is the sector trading strategy. But what is the sector trading strategy all about?

The sector trading strategy is a technique of trading the various S&P 500 sector ETFs during different phases of the business cycle to maximize returns. Different sectors of the market perform best in different phases of the business cycle. Investors try to benefit from this by trading different sector ETFs at different periods of the market cycle.

To understand more about the various sectors of the market and sector rotation, keep reading.

What are the 11 sectors of the stock market?

A stock market sector is a group of stocks from similar industries that serve the same needs in society. The S&P 500 Index consists of 11 market weighted sectors from 24 industry groups, according to the Global Industry Classification Standard (GICS) created by Standard & Poor’s (S&P) and Morgan Stanley Capital International (MSCI).

The S&P categorizes companies into sectors based on their primary business activity to make it easy to compare companies that have similar business models. With the categorization, it is easier to compare which stocks and sectors are making the most money so investors make decisions about what their next investments will be. Investors can choose from stocks within the sectors that interest them or invest in ETFs that tracks the various sectors.

Here is a list of the 11 sectors of the S&P 500 index:

  1. Technology
  2. Healthcare
  3. Consumer discretionary
  4. Communication services
  5. Financial services
  6. Industrials
  7. Consumer staples
  8. Utilities
  9. Materials
  10. Real estate
  11. Energy

Stocks in the S&P 500 index are market-weighted and this affects the weightings of the various sectors in the index. As such, the performances of the information technology, health care, consumer discretionary, and communication services exert a much greater impact on the performance of the S&P 500 Index than those of the utilities, real estate, materials, and energy sectors.

Now, let’s take a look at the various sectors and the ETFs that track them.

Technology (VGT, XLK)

Referred to as the information technology or IT sector, it consists of companies that develop or distribute technological items or services, such as computers, microprocessors, operating systems, and special software. Example of companies in this sector includes big names like Microsoft Corporation, NVIDIA Corp, Oracle Corp., Adobe Inc, and Apple Inc.

Some of the popular ETFs that track the Information technology sector include the Vanguard Information Technology ETF (VGT) and the Technology Select Sector SPDR Fund (XLK).

Healthcare (VHT, XLV)

This sector includes biotechnological companies, pharmaceutical companies, medical supply companies, and companies that offer services that aim to improve the human body or mind. Popular examples include Johnson & Johnson, a medical device and pharmaceutical company that owns Tylenol, and Abiomed, which manufactures medical implant devices. Recently, there are also cannabis companies, such as Canopy Growth Corp. and Aurora Cannabis.

Popular ETFs that track the sector include the Vanguard Health Care ETF (VHT) and the Health Care Select Sector SPDR Fund (XLV).

Consumer Discretionary (VCR, XLY, XLP)

Discretionary consumer products are goods or services that are not necessary for survival. They include cars, jewelry, sporting goods, and electronic devices, as well as hotel services, tourism, and so on. The demand for these items depends on economic conditions and the wealth of individuals. Some examples of companies in this sector include Tesla, Nike, Toyota, Starbucks, Best Buy, and Amazon.

Examples of ETFs that track this sector include Vanguard Consumer Discretionary ETF (VCR) and Consumer Discretionary Select Sector SPDR Fund (XLY).

We have made a separate article where we discuss the sector in more detail and we even include trading strategies and backtests:

Communication Services (VOX, XLC)

The companies in this sector help to keep people connected. They include internet providers and phone plan providers, as well as media, entertainment, and interactive media & services companies. Examples include Alphabet (Google parent company), Meta (previously Facebook), AT&T, Verizon, T-Mobile, and CBS Corp. Netflix Inc. and Walt Disney Co. are also considered part of this sector.

The ETFs that track the sector include Vanguard Communication Services ETF (VOX) and Communication Services Select Sector SPDR Fund (XLC).

Financial Services (VFH, XLF)

Companies in this sector are involved in finance, investing, and the storage or transfer of money. This includes banks, credit card issuers, credit unions, insurance companies, and mortgage real estate investment trusts (REITs). The companies here are usually relatively stable and well-established firms. Examples include Bank of America Corp, JPMorgan Chase & Co., Goldman Sachs, Berkshire Hathaway, American Express, Visa, MasterCard, and Aon plc.

Vanguard Financials ETF (VFH) and Financial Select Sector SPDR Fund (XLF) are some of the popular ETFs that track this sector.

In a separate article we covered the sector in detail. The article includes both a trading strategy and backtest:

Industrials (VIS, XLI)

This sector covers a wide range of companies that make use of heavy equipment. The companies here engage in aerospace, defense, construction, and engineering. Companies in transportation, such as airlines, railroads, and logistics companies are found within this sector, as are companies involved in electrical equipment and machinery.

The ETFs that track this sector include Vanguard Industrials ETF (VIS) and Industrial Select Sector SPDR Fund (XLI).

The XLI is not a widely used trading vehicle, perhaps for good reasons (?). However, in the article where we covered the sector in detail, we included both a trading strategy and backtest:

Consumer Staples (VDC, XLP)

Consumer staples products include goods and services that people need, regardless of their current financial condition. These include food, beverage, and tobacco, as well as household items and toiletries. Examples of companies here include Procter and Gamble, Unilever, Coca-Cola, and PepsiCo. It also includes retail companies that specialize in selling staples, such as supermarkets — Walmart.

Consumer Staples Select Sector SPDR Fund (XLP) and Vanguard Consumer Staples ETF (VDC) are the most popular ETFs that track the sector.

We believe the consumer staples is the best trading sector of the stock market, hands down. It’s mostly ignored by most gtraders, and that is perhaps good. that means less competition!

We have covered the sector extensively and we have given many free trading strategies for the consumer staples sector:

Utilities (VPU, XLU)

The utilities sector encompasses any type of utility company you can think of, including companies that specialize in electrical power distribution and those that distribute natural gas and supply water to households. Renewable energy companies are also included in the utilities sector.

The ETFs that track the sector are Utilities Select Sector SPDR Fund (XLU) and Vanguard Utilities ETF (VPU).

The consumer staples sector is an underrated trading sector, and so is utilities. We trade utilities ourselves, and for good reason. The sector is completely different compared to the overall market and offers great diversification.

Materials (VAW, XLB)

This sector includes companies that provide raw materials used in manufacturing and other industrial applications. Examples are mining companies and those that specialize in making paper and forest products, as well as companies that produce chemicals, construction materials, and containers.

Vanguard Materials ETF (VAW) and Materials Select Sector SPDR Fund (XLB) are the main ETFs that track this sector.

Real Estate (VNQ, XLRE)

The companies here are involved in developing new real estate projects and managing them by obtaining tenants for various spaces within the project property. They include real estate investment trusts (REITs), which are special tax-favored business entities that operate in various areas of the real estate industry. Some of the stocks here include American Tower Simon Property Group.

The major ETFs that track the sector are Real Estate Select Sector SPDR Fund (XLRE) and Vanguard Real Estate ETF (VNQ).

Just like utilities and the consumer staples, the real estate sector is a great trading vehicle for diversification.

Energy (VDE, XLE)

This sector covers companies that do business in the oil and natural gas industry and other fossil fuels. It doesn’t include many renewable energy companies, which instead are considered utilities. The companies in this sector are either involved in oil and gas exploration and production, the production and supply of other consumable fuels like coal and ethanol, and other support services like the supply of equipment to oil and gas producers.

Vanguard Energy ETF (VDE) and Energy Select Sector SPDR Fund (XLE) are the major ETFs that track the energy sector.

What is sector rotation?

Sector rotation is a stock market investing strategy that involves moving money from one stock market sector to another to profit from the different phases of the economic cycle. As you may already know, the economy and the stock market move in cycles, and different sectors tend to perform better in certain phases of the cycle.

So, investors try to make the most of the phases of the economic cycle by moving their funds from sectors that are likely to underperform to sectors that are likely to perform well in any given phase of the cycle.

One of the bases for sector rotation strategies is that stocks from the same sector and industry tend to move in similar patterns, as they are often affected by similar fundamental and economic factors. Because their business models and operations are similar, they have similar economic exposure and sensitivities, and as such, they move in the same way in a given phase of the economic/market cycle.

For instance, the IT sector grew very fast in the early 2000s, with most stocks in that sector performing extremely well. In a similar way, most stocks in the financials sector had a sharp decline during the great recession of 2008-2009 caused by the collapse of the subprime mortgage market.

The pan-sector rally in the IT sector in the early 2000s and the pan-sector decline in the financials sector during the great recession show that stocks in the same sector often exhibit similar performance during a particular phase of the economic/market cycle. This is why investors use the sector rotation technique and rotate their funds around the ETFs that track the various sectors.

We have made many free sector rotation strategies over the years:

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