Sector Rotation Analysis: A Practical Tutorial Using TradingView

Sector Rotation Analysis: A Practical Tutorial Using TradingView

Overview
Sector rotation is an investment strategy that involves reallocating capital among different sectors of the economy to align with their performance during various phases of the economic cycle. While academic studies have shown that sector rotation does not consistently outperform the market after accounting for transaction costs, it remains a popular framework for portfolio management.
This tutorial provides a step-by-step guide to analyzing sector rotation and identifying leading and lagging sectors using TradingView.


Understanding Sector Rotation and Economic Cycles
The economy moves through distinct phases, and each phase tends to favor specific sectors:

• 1. Expansion: Rapid economic growth with rising consumer confidence.
  - Leading Sectors: Technology XLK, Consumer Discretionary XLY , Industrials XLI
• 2. Peak: Growth slows, and inflation may rise.
  - Leading Sectors: Energy XLE , Materials XLB
• 3. Contraction: Economic activity declines, and unemployment rises.
  - Leading Sectors: Utilities XLU, Healthcare XLV, Consumer Staples XLP
• 4. Trough: The economy begins recovering from a recession.
  - Leading Sectors: Financials XLF, Real Estate XLRE

Step 1: Use TradingView to Monitor Economic Indicators
Economic indicators provide context for sector performance:

• GDP Growth: Signals expansion or contraction.
  
• Interest Rates: Rising rates favor Financials; falling rates benefit Real Estate.
  
• Inflation: High inflation supports Energy and Materials.
  

Step 2: Analyze Sector Performance Using Relative Strength
Relative Strength RS compares a sector's performance against a benchmark index like the
SPX This helps identify whether a sector is leading or lagging.

How to Calculate RS in TradingView

• Open a chart for a sector ETF, such as XLK Technology.
  
• Add SPX as a comparison symbol by clicking the Compare ➕ button.
  
• Analyze the RS line:
  - If RS trends upward, the sector is outperforming.
  - If RS trends downward, the sector is underperforming.
  

Using Indicators

• e.g.: You may add the Sector Relative Strength [Afnan] indicator from TradingView’s public library. This tool ranks multiple sectors by their relative strength against SPX
• Additionally, you can use the RS Rating indicator by Fred6724, which calculates the Relative Strength Rating (1 to 99) of a stock or sector based on its 12-month performance compared to others in a selected index.
  

Example
In early 2021, during economic recovery, XLK's RS rose above SPX, signaling Technology was leading.

Step 3: Validate Sector Trends with Technical Indicators
Technical indicators can confirm sector momentum and provide entry/exit signals:

Moving Averages

• Use 50-day and 200-day Simple Moving Averages SMA.
  
• If a sector ETF trades above both SMAs, it indicates bullish momentum.
  

Relative Strength Index RSI

• RSI > 70 suggests overbought conditions; <30 indicates oversold conditions.
  

MACD Moving Average Convergence Divergence

• Look for bullish crossovers where the MACD line crosses above the signal line.
  

Example
During the inflation surge in 2022, XLE Energy traded above its 200-day SMA while RSI hovered near 70, confirming strong momentum in the Energy sector.

Step 4: Compare Multiple Sectors Simultaneously
TradingView allows you to overlay multiple ETFs on one chart for direct comparison:

• Open SPY as your benchmark chart.
  
• Add ETFs like XLK, XLY, XLU, etc., using the Compare tool.
  
• Observe which sectors are trending higher or lower relative to SPY

Example
If XLK and XLY show upward trends while XLU remains flat, this indicates cyclical sectors like Technology and Consumer Discretionary are outperforming during an expansion phase.

Step 5: Implement Sector Rotation in Your Portfolio
Once you’ve identified leading sectors:

• Allocate more capital to sectors with strong RS and bullish technical indicators.
  
• Reduce exposure to lagging sectors with weak RS or bearish momentum signals.
  

Example
During post-pandemic recovery in early 2021:

• Leading Sectors: Technology XLK and Industrials XLI
• Lagging Sectors: Utilities XLU

Investors who rotated into XLK and XLI outperformed those who remained in defensive sectors like XLU

Real-Life Case Studies of Sector Rotation

Case Study 1: Post-Pandemic Recovery
In early 2021, as economies reopened after COVID-19 lockdowns:

• Cyclical sectors like Industrials XLI and Financials XLF outperformed due to increased economic activity.
  
• Defensive sectors like Utilities XLU lagged as investors shifted away from safe havens.
  

Using TradingView’s heatmap feature, investors could have identified strong gains in XLI and XLF relative to SPY

Case Study 2: Inflation Surge in Late 2022
As inflation surged in late 2022:

• Energy XLE and Materials XLB outperformed due to rising commodity prices.
  
• Technology XLK underperformed as higher interest rates hurt growth stocks.
  

By monitoring RS lines for XLE and XLB on TradingView charts, investors could have rotated into these sectors ahead of broader market gains.

Limitations of Sector Rotation Strategies

• Transaction Costs: Frequent rebalancing can erode returns over time.
  
• Market Timing Challenges: Predicting economic cycles accurately is difficult and prone to errors.
  
• False Signals: Technical indicators like MACD or RSI can produce false positives during volatile markets.
  
• Historical Bias: Backtested strategies often fail when applied to future market conditions.
  

Conclusion
Sector rotation is a useful framework for aligning investments with macroeconomic trends but should be approached with caution due to its inherent limitations. By leveraging TradingView’s tools, such as relative strength analysis, heatmaps, and technical indicators, investors can systematically analyze sector performance and make informed decisions about portfolio allocation.

While academic research shows that sector rotation strategies do not consistently outperform simpler approaches like market timing or buy-and-hold strategies, they remain valuable for diversification and risk management when used judiciously.