In this 4 part series, a new market timing indicator will be described. Then the indicator will be combined with the collection of other indicators to produce a new combined market timer. The consensus market timer will be used to "frame" a sector rotation strategy that will be based on the same set of sector-related signals as the newly developed market timer.
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Part 1 provides a general overview of the sector rotation strategy. Part 2 describes the setup of the necessary custom series'. Part 3 will demonstrate a new market timer based on this sector rotation strategy. Part 4 will go on to use the new consensus market timer in conjunction with the new sector rotation strategy.
Part 3 Preview - Market Timing
The underlying sector rotation strategy is based on the market cycle wheel (shown below). The idea is to determine what side of the black dashed line the market is sitting in. The algorithm that will be used, calculates the (quasi-)differential of the Income Yield (Income Available to Common Shareholders / Market Capitalization) for each sector aggregate.
The number of sectors that have rising Income Yield from the left side versus the right side of the wheel determines whether the market has strength or weakness. (Note: the two figures are normalized by dividing the left count by 5 and the right count by 4).
The allocation of the sectors to one side or the other was determined empirically, in particular the Discretionary and Energy sectors. The traditional business cycle places the Discretionary sector in the recession bucket, and energy is put in the late economic expansion bucket. However, the stock market is anticipatory, thus it is necessary to shift the whole diagram clockwise by one sector for best results.
While not an extraordinary market timer unto itself (as compared to #UNEMP for example), this sector-based strategy does provide added benefit to a battery of market timing algorithms. A backtest of this timer switching between S&P 500 (ETF Symbol: SPY) and 1-3 Yr Treasury Bonds (ETF Symbol: SHY) is shown below.
Part 4 Preview - Sector Rotation With Market Timing
Using a consensus of 6 market timers (including the newest sector rotation timer), the same sector rotation strategy is employed, not to time the market, but to assist in determining which SPDR sector ETF to buy. Or, depending on the status of the market timers, 10 Year Treasury Notes (ETF Symbol: IEF) is purchased instead. A backtest of the sector rotation model is shown below.
Part 2 will focus on creation of the 9 custom series required for implementing this sector rotation strategy.