Sectors: Rotation, risk and return – Part One

Nifty is down by 19% as on July 27th, 2012 from its historical high that was registered in November 2010. We have looked indices in two parts, performance since the sub-prime crisis low and November 2010 high. We see that all indices we have looked at for this piece are still in redsince November 2010 high though these indices have given exceptional returns since the crisis low of 2524 in October 2008, Realty being the exception. Auto has been the top performer returning more than 260% since the crisis low followed by IT (134%), Metals (114%) and Consumption (114%) and these four sectors outperformed since the November 2010 high too though Consumption (-2%) led the pack. Metals which were one of the top performers since the crisis low got walloped down by 43% since November 2010.

The sector rotation is a prominent investment approach seen among long term investors. We know that an economy goes through cycles, from trough to peak and back to trough,and in a cycle it undergoes various phases like early recovery, full recovery, early recession and full recession. The idea behind sector rotation is that at each phase some sectors outperform others, for instance during recession healthcare and utilities outperform sectors like capital goods and materials. For sector rotation to work there should be some negative correlation between the sector that is expected to outperform and the sector that is expected to underperform. But as shown in the table below we see that correlations between all the indices and Nifty and also between each other are positive,that too very strong positive correlation. The only odd men so to say are, as expected, Pharma and IT sectors with weak correlations but still well above zero.

As mentioned above we see that all sectors move in tandem though magnitudes of moves differ. A point to be noted is that correlation tells us whether two variables move in same direction or not and not the amount by which the variables move. For sector rotation negative correlations between sectors are highly preferred but in our market since all sectors are strongly correlated hence long only sector rotation approach may not work.

Moreover when we look at the historical correlation of sectors with Nifty, the chart given below,tells us that though we see bouts of weak correlations those are still well above zero. Hence in Indian context outperformance by a sector over others still doesn’t mean positive return but lesser loss from the sector that outperforms.

Better approach for Indian market instead of plain long only sector rotation is the long short market neutral strategy. The added benefit of this strategy is that the market risk is hedged and irrespective of market direction the strategy might make money if one gets the call on the sector that would outperform right.