To understand ETF Sector Rotation trading imagine you were able to keep betting on the leading horse as it went around the race track.
As a horse takes the lead, you move your bet from the ETF leader to the new one.
Keep doing this as the horses round the track and you could win every time.
Money chases Performance
Of course, no race track in the world would let you have such a lopsided edge over them.
Yet in the stock market that's exactly what happens - money chases performance much as chasing a leading horse.
Extreme examples include the late 90's NASDAQ stocks and the roaring 1920s.
There's No fancy indicator For ETF Sector Rotation
Now imagine, for a second, that the whole stock market acted like a giant balloon and the air inside this balloon was money.
If you press on one part of the balloon, the air (money) inside simply goes to another part of the balloon.
Money gets pushed from of part of the stock market to another.
It goes where it’s most welcome, and when it disappears in a flash from one area, it always reappears somewhere else.
It's what's called "self-axiomatic" or as our Declaration of Independence words it: "self-evident."
So what's the magic indicator of all ETF sector rotation?
It's just the price!
We literally just follow the money.
How To Find The Stock Market’s “Leading Horse”
The great thing about ETF sector rotational trading is that the only indicator you need is the market itself.
You don’t need to pour through earnings reports, analysts' upgrades/downgrades, or PE ratios.
The list of useless garbage from the financial industry goes on ad infinitum.
Everything you ever need to know about a stock is neatly wrapped up for you in a package called price.
Prices are a measure of the average "guess" of what a company is worth.
It's a guess made by millions of traders and investors out in the world.
Yes, you really can find the next Amazon or Apple with this freely available price data that sits in the public domain.
The key is to measure stock price behavior objectively.
So how is it done?
ETFs trend for long periods of time, i.e., they keep going up, or they keep going down.
There are some that just chop around sideways like dividend-paying stocks, and we don’t want to look at those.
We want to only look at ETFs that are in strong up-trends.
All my testing has shown again and again that the best way to find these ETFs is to look at their six-month percentage return and their three-month percentage return.
You want to see the three-month return accelerate over the six-month return
Sounds simple enough, but the problem is that you must run these calculations over the entire universe of ETFs every day.
There are around 2,200 ETFs traded on U.S. exchanges alone so you can’t do that by hand.
You have to write a computer program to do that for you.
This is where most people give up, and sadly they are missing out on massive returns if they just spent the time to learn a few basic computer languages.
ETF Sector Rotation Is Not A New Idea
The first time I read about ETF sector rotation was in a newsletter in the early 2000s, and I’m willing to bet the idea is much older than that.
The newsletter’s idea was to switch from ETF to ETF on the first day of the month.
And it even used that same great racetrack analogy for this type of active portfolio management.
Unfortunately, the newsletter's original idea of rotational investing was a failure because it was an incomplete strategy.
When I tested the newsletter’s ideas, I found this fundamental flaw, and not surprisingly, like so many other investing newsletters, it no longer exists.
It misled people into thinking they were safe in ETFs alone.
After running my testing, I noticed their system lost huge amounts of money whenever the stock market took a turn for the worst.
They never got out of stocks during huge market declines!
Making ETF Sector Rotation Trading Even Better
When the stock market falls apart, the entire house of cards tends to crumble.
The best stocks turn into the worst stocks, and the worst stocks perform even worse.
It’s often a race to the bottom.
So how do you know when to get out of ETFs completely?
If an ETF trades below its 200-day moving average, sell it immediately.
Or if the Russell 2000 index makes a new six-month closing low, SELL EVERYTHING!
That makes sense, right?
The edge there is tremendous.
This can be fully automated processes, and the results are extraordinary!
How Many Leading Horses To Trade?
Now, “diversification” is a fuzzy line.
Most traders and “experts”, say that you should be as diversified as possible, and entire financial television shows are dedicated to telling their audience whether they’re diversified enough.
However, if the experts took the time to test their ideas, they would see that it’s all complete garbage.
You might have noticed that when things are very bad in the stock market, all stocks seem to go down together.
From years of testing, the number 10 keeps coming up for the number of ETFs to own when a sector rotational trading system says to buy stocks.
Ten is a sweet spot that gives you the ability to absorb a hit from a few bad stocks while the others continue to churn higher.
And once the new month rolls around you sell those bad stocks and replace them with better performers.
Making Your Own ETF Sector Rotation Trading System
You can absolutely take everything I’ve laid out here and set up your own ETF sector rotation trading system using your home PC and a spreadsheet.
But if you really want to take it to the next level, you’ll need to get your hands dirty with a little programming, which is exactly what I did.
It took me a long time to come to these conclusions, and like all things, you need to put in the work to see results.
But the good news is that by putting in the right kind of work, life gets a whole lot easier.
It’s all about working smarter, not harder.
Knowledge is power, but in a world where information is practically infinite, a strategy is necessary to identify the important from the unimportant.
I hope you found this explanation of rotational trading helpful.
If you have any questions or doubts about it, let me know in the comments.
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Hi there. You can subscribe by going to my homepage to get all the latest updates. Cheers, -Kurt