This article “Sector Rotation: Constructing Portfolio with Defensive and Non-Defensive Stocks” was written by Sergey Okun – Senior Financial Analyst at I Know First, Ph.D. in Economics.

Highlights:

• Different stages of the stock market require stock selections that are more suitable in the current macroeconomic environment.
• The strategy based on sector rotation in periods of expansion and recession can generate an additional excess annual return compared with the stock market return.
• I Know First provides the ETFs package based on the AI algorithm to find the most promising investment opportunities according to the macroeconomic environment.

Different stages of the stock market require stock selections that are more suitable in the current macroeconomic environment. One of the classical selection methods is to group stocks into defensive and non-defensive stocks. Defensive stocks are the ones that are more or less immune to changes in market conditions. A defensive stock features a stable demand for its products and services during the various phases of the business cycle. Defensive stocks tend to perform better than the broader market during recession. However, during an expansion phase, they tend to perform below the market. At the same time, non-defensive stocks or cyclical stocks are dependent on the changes in the overall economy. These stocks represent the companies whose profit is higher when the economy is prospering. These companies’ returns are in tandem with the health of the economy.

Let us analyze the performance of the investment strategy based on defensive and non-defensive stock sectors in periods of expansion and recession. We use data for the 10 industry portfolios from the Kenneth French website. The data set provides monthly returns since July 1926 (1160 months) for the following industrial portfolios: Consumer Nondurables, Consumer Durables, Manufacturing, Energy, HiTech, Telecom, Shops, Healthcare, Utilities, and Others. Let us group these sectors into two groups: defensive and non-defensive stocks. The defensive stocks group includes Consumer Nondurables, Telecom, Shops, Healthcare, and Utilities. The non-defensive stocks group includes Consumer Durables, Manufacturing, Energy, HiTech, and Others. We use NBER based Recession Indicator to identify an expansion or recession environment. Also, we control our estimation of the market premium return, size and book-to-market factors.

We construct the following equal-weighted portfolio to test its performance based on the macroeconomic environment.

There is an output of the econometric model below

We can notice the exposures to size and book-to-market factors of the sector rotation strategy are small of 0.0285 and 0.0503 consequently, at the same time the market beta is 0.9730, while there is a positive alpha of 0.2313. Moreover, our regression can explain around 93% of the deviation in market excess return (the market return minus risk-free rate). It is important to notice that all our estimators are statistically significant, according to the p-value. Especially we are interested in the significance of alpha which means that this sector rotation strategy generated the positive alpha.

According to Figure 3, the sector rotation strategy generates an additional excess annual return of 2.98% compared with the excess market return, with the Sharpe ratio of 0.50 versus the market Sharpe ratio of 0.35.

Selecting Sectors with I Know First

I Know First has constructed ETFs package to provide preditions based on the AI algorithm. This package helps to identify the most promising investment opportunities for 3-day, 7-day, 14-day, 1 month, 3-months, and 1-year investment horizons.

I Know First is one leading company that has been effectively using machine learning and AI-based algorithms to provide daily forecasts and facilitate trading for over 13,500 financial instruments. More importantly, I Know First’s algorithm can fulfill the idea of discovering “fractals” and patterns using a more accurate way through AI and machine learning without involving any human judgments. The algorithms can present historical price patterns based on the data inputs, testing the performance on years of market data, and validating them on the most recent data to prevent overfitting. If an input does not improve the model, it is “rejected”, and another input can be submitted. I Know First provides different forecast packages based on the AI algorithm which allows us to select the most promising stocks (you can access them here). Also, I Know First offers daily forecasts for the GICS Sector and Industry Map that enable our clients to find promising investment opportunities by taking into account the fundamental dynamics of economic sectors and industries throughout the business cycle. For example, below you can see the investment result of our ETF Industries and ETF Sectors packages which were recommended to our clients.

Package Name: ETF Industries Forecast
Recommended Positions: Long
Forecast Length: 7 Days (4/6/23 – 4/13/23)
I Know First Average: 2.0%

Package Name: ETF Sectors Forecast
Recommended Positions: Long
Forecast Length: 14 Days (3/31/23 – 4/15/23)
I Know First Average: 2.19%

As we can see, the I Know First AI algorithm provides successful stock market forecasting across Industrials and Sectors ETFs. If you are interested in any of the packages mentioned above, you can have access to it here.

Sector Rotation: Conclusion

Different stages of the stock market require stock selections that are more suitable in the current macroeconomic environment. We have got evidence that the investment strategy based on defensive and non-defensive stock sectors in periods of expansion and recession can generate an additional excess annual return compared with the stock market return. At the same time, I Know First provides the ETFs package based on the AI algorithm. This forecast package can help to find the most promising investment opportunities according to the current macroeconomic environment and changes in the structure of the financial market.

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Please note-for trading decisions use the most recent forecast.