Stock Market Sector Investing, Use Fundamental or Technical Analysis?

By: Hans_Wagner

Sector rotation investing is a successful strategy that takes advantage of the stages of the business cycle to identify industry groups that are more likely to outperform the market in each stage. Sam Stovall helped to highlight the value of sector rotation investing with his book titled Standard & Poor's Guide to Sector Investing 1995.

Since then investors have been debating the value of fundamental vs. technical analysis when analyzing sector rotation. Today, we will explore this issue and shed some light on what investors should consider.

Stock Market Sector Background

Sam Stovall states that different sectors are stronger at different business cycle phases. The table below describes this theoretical model showing the four phases of the business cycle.

This table provides a simple view of the economy and the interaction of some of the important components used by investors to assess its performance. As investors, we need to keep in mind that economists spend their entire lives studying the economy and they miss the major shifts that take place. For example, how many accurately predicted the recent recession before it happened? While I do not have a count, I can tell you that very few made such claims before the event. So what makes investors think they can identify the major turning points of the economy any better?

This does not mean that investors should not pay attention to the performance of the economy and of important industry sectors that might offer above average returns. Rather you should recognize that there are limits to what we can know about the future of the economy and each industry. This insight might help to identify important trends that become the primary forces behind a major economic move.

The Fundamentalist Approach

Those who advocate the fundamental approach examine the economics of each sector. They are seeking to identify what will cause one sector to perform better or worse than another. Some of the factors they examine include the most important risks the sector will encounter, the growth rates of the sector, how they have done historically, and what is different this time. While this information is useful, it is very similar to what economists use, making it subject to the same errors of judgment. Yet this knowledge provides a good way to think through the reasons one industry is more likely to outperform another.

The advent of Exchange Traded Funds (ETFs) has changed the way investors can look at sector investing. ETFs are funds comprised of stocks based on an index, trade just like stock. Unfortunately, the standard metrics such as P/E ratios, book value, cash flow analysis, and my favorite free cash flow yield, etc, are unable to offer much help when analyzing sector based ETFs. Perhaps some day an investment research group will derive the necessary data to give investors the information to perform customary fundamental analysis. Until then investors who want to use fundamental analysis to evaluate sectors face the same problems as economists, since financial statements that cover the entire sector are not available, like they are for stocks.

Technical Approach

Technical analysis tries to identify what is the driving investor psychology as it is reflected in the share price. Using chart patterns, support and resistance, as well as a growing set of indicators, technicians look at price and volume to discover where the share price is most likely to go over a specific period of time.

Fortunately, technical analysis does not care if the tools are for a specific stock or for the entire market. The tools work well for each end of the spectrum as well as anything in between. As a result, technicians are able to offer their analysis of any sector using ETFs just like any stock or market index. This gives technical analysts an important advantage over those that only follow fundamental analysis when evaluating industry sectors.

The Bottom Line

The question whether investors should use fundamental or technical analysis when considering sector rotation strategies should focus on which approach provides the best results. Unfortunately, I have not been able to find any study that provides tangible proof either way. As a result, we are left to what has worked based on our own experience.

I have found that a blend of fundamental and technical analysis works the best. Fundamental analysis provides the strategic framework to decide where the best opportunities might lie. Whereas, technical analysis provides investors a logical basis for entry and exit points.

While not definitive, a blend of the strengths of each approach offer investors a rational way to assess the strength and weakness of each industry sector as well as where are the best entry, stop and exits.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2009 Hans Wagner

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