Two-Stage Sector Rotation Methodology Using Machine Learning and Deep Learning Techniques

Abstract: Market indicators such as CPI and GDP have been widely used over decades to identify the stage of business cycles and also investment attractiveness of sectors given market conditions. In this paper, we propose a two-stage methodology that consists of predicting ETF prices for each sector using market indicators and ranking sectors based on their predicted rate of returns. We initially start with choosing sector specific macroeconomic indicators and implement Recursive Feature Elimination algorithm to select the most important features for each sector. Using our prediction tool, we implement different Recurrent Neural Networks models to predict the future ETF prices for each sector. We then rank the sectors based on their predicted rate of returns. We select the best performing model by evaluating the annualized return, annualized Sharpe ratio, and Calmar ratio of the portfolios that includes the top four ranked sectors chosen by the model. We also test the robustness of the model performance with respect to lookback windows and look ahead windows. Our empirical results show that our methodology beats the equally weighted portfolio performance even in the long run. We also find that Echo State Networks exhibits an outstanding performance compared to other models yet it is faster to implement compared to other RNN models.