The Best Ways to Play Sectors Right Now

by Chris Johnson | August 1, 2012 9:38 am

Apparently, there’s some dissension in the ranks.

Stocks have seen a major change in trend lately — namely, the number of stocks moving in tandem has dropped. Looking at the S&P 100 Index, the average correlation of the index’s 100 stocks against the index itself has dropped from more than 70% at the beginning of 2012 to a current average of just 50%.

The drop in correlation indicates that stocks are not migrating higher together, but instead, a greater number of stocks are moving independent of the market. That has two major implications:

  1. Lower-correlation markets typically are an indication that the market is running into a weaker period, as less uniformity in stocks can confuse and even discourage markets. Conversely, the highest-correlation periods occur when the market has made a long-term bottom. This often is referred to as the “tide lifting all boats,” as strong market rallies tend to sweep all stocks higher.
  2. Low-correlation markets favor stock picking versus index or sector investing, as stocks are not moving in tandem — meaning the differential is growing between stocks that are rewarding and those that are losing.

The low-correlation environment is beginning to put pressure on investors to find the right plays to avoid getting sucked into the splintering market. In some cases, it still makes sense to stick with some strong-performing ETFs, while in others it’s best to opt for the strongest-performing stocks in an ETF instead of holding a directionless fund.

Let’s start by looking at those ETFs that still are offering market-bearing results. The table to the right displays the widely traded ETFs (according to average daily volume) along with their current relative strength against the S&P 500.

Not surprisingly, many of the ETFs at the top of the list (those currently beating the market) are of a defensive nature, as investors are moving into what they think are risk-adverse investments to weather the rest of the summer.

For our money, the biotech (NYSE:XBI[1]), real estate (NYSE:IYR[2]), dividend (NYSE:DVY[3]) and telecommunications (NYSE:IYZ[4]) ETFs are among the more attractive alternatives for investors seeking returns from sectors that are more likely to hold a higher correlation of performance among their constituent companies.

Simply put: These sectors are less likely to be splintered by a widening gap between the top- and bottom-performing companies within the ETFs, meaning you can expect more robust and reliable performance.

The question often passes our desk, “What if we like a sector, but the ETF is underperforming?” This is the exact case our analysis has found with a few of the funds at the bottom of this list, namely the retail (NYSE:XRT[5]), insurance (NYSE:KIE[6]) and consumer discretionary (NYSE:XLY[7]) ETFs.

Our research continues to suggest that we should be taking exposure in these ETFs; however, the lack of performance correlation makes it hard to actually invest in the ETFs themselves. In these cases, the best approach is to drill down into the ETF constituent companies in search of the best alternative to the ETF.

If you look at the retail, insurance and consumer discretionary ETFs, you’ll see much better single-stock alternatives given the relative strength performance figures for each of their constituent companies. The three tables below display these single-stock alternatives for XRT, XLY and KIE. Keep in mind that by investing in these companies instead of the ETFs, you are taking on company-specific risk that the ETFs are meant to overcome; however, in the current market of non-correlating returns, accepting additional company-specific risk will be the only way to beat the market.

As of this writing, Chris Johnson did not hold a position in any of the aforementioned securities.

  1. XBI:
  2. IYR:
  3. DVY:
  4. IYZ:
  5. XRT:
  6. KIE:
  7. XLY:

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