by Tyler Craig | February 26, 2013 8:32 am
Over time, the financial wizards of Wall Street have dissected the stock market into virtually every conceivable division. Like excited kids over a game of Operation, they’ve sliced and diced the multitude of stocks into carefully crafted categories — growth, value, emerging markets, low beta, high yields, frontier, cyclicals, large caps, and countless others.
Of course, the advent of exchange-traded funds merely served to propel these efforts as institutions became able to create trading vehicles that track everything from China infrastructure and Vietnam to biofuel and nickel. While tracking every little segment of the market is perhaps too time-consuming, most traders can improve their trading performance by at least tracking sector performance.
Think of a sector as a broad basket containing stocks of a similar nature — like energy or financials. Unfortunately, the Street lacks consensus on the exact number of sectors. Some say there are nine, others say 13. The breakdown I favor divides the S&P 500 into nine overall sectors using ETFs called the Select Sector SPDRs.
One interesting aspect of analyzing sector performance is the ability to gauge market health. We can break the nine major sectors into two groups — offensive and defensive. The offensive group includes consumer discretionary, financials, industrials, basic materials and technology. The defensive group includes health care, utilities and consumer staples.
In general, the offensive sectors tend to be more economically sensitive and more volatile, and offer higher returns. During bull markets, these sectors should lead as investors seek to maximize their return on capital.
In contrast, the defensive sectors tend to be less economically sensitive and less volatile, and are perceived as safer investments. During bear markets, these sectors usually lead as investors are more interested in protecting their capital.
Alongside the recent downturn in stocks, sector rotation has been flashing some definite warning signs. Take a look at the accompanying graphic, which shows the relative sector performance over the past week. Amid the volatile market action, investors shifted into defensive sectors, with consumer staples boasting the best performance.
While one week of defensive leadership might not result in a huge market correction, it does at least warrant caution for traders in the short-run. In light of this rotation, I suspect neutral-to-bearish plays might finally receive their day in the sun.
One trade worth consideration is selling out-of-the-money April call spreads in the Russell 2000. Because this index is comprised of small-cap stocks, it usually gets hit hardest during market downturns.
To enter the position, sell the April 960 call while buying the April 970 call for a net credit of $1.20 or better. The max reward is limited to the initial $1.20 received and will be captured provided the Russell remains beneath $960. The max loss is limited to the distance between strikes minus the net credit, or $8.80, and will be incurred if the Russell rises above $970.
As of this writing, Tyler Craig held neutral positions on the Russell 2000 Index.
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