Many commentators, fund managers and investors are bullish on stocks and commodities and bearish on bonds for 2011. There are strong fundamental and technical reasons to have these views, and I don’t strongly disagree.

However, I think to do better than the overall market in 2011 will require a little more than these three generally accurate macroeconomic calls.

Understanding sector rotation in its various forms will be the key to success.

The first kind of sector rotation relates to countries and regions of the world. Last year Asia, excluding China and Japan, and Latin America were top regional performers. Smaller countries with resource intensive markets such as Australia, South Africa and Canada also did very well.

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The U.S. trailed, while Europe and Japan did even worse. There are strong reasons to believe the U.S. will do better in 2011, possibly even perform better than any other developed country. Quantitative easing, the tax deal, the third year of the presidential cycle and improving employment conditions all point to more solid performance for U.S. markets.

Japan could do better, relatively, if the yen weakens, but that is a big question mark. Europe could do better if its leaders resolve their currency and debt problems, but that is also surrounded by uncertainty.

Emerging markets are likely to do worse in 2011 for reasons including high inflation, higher interest rates, too much hot money looking to sell at the first sign of weakness and relatively high valuations against historical averages.

Another kind of sector rotation relates to larger versus smaller capitalizations markets. Last year smaller capitalization markets, whether in stocks, bonds, commodities or countries, did much better. Valuation and sentiment in smaller cap markets is extremely overextended and due for at least a very strong correction if not an outright bear market. Smaller cap markets that are particularly vulnerable include precious metals, resource intensive countries, exotic and emerging market bonds and small cap stocks in hot sectors such as mining and Internet technology.

The flip side is that many larger cap markets are relatively undervalued and should do better in 2011. These include larger cap stocks, especially value oriented shares, bigger commodity markets such as energy and industrial materials, more liquid bonds (excluding Treasuries), and bigger developed regional markets such as the U.S.

A third kind of sector rotation is high versus low quality. In 2010 low quality assets generally performed better than high quality assets. This was especially true with stocks and bonds. This should reverse in 2011 for many of the same reasons explained above related to small versus large cap markets. Higher quality assets tend to have bigger active markets and are more liquid than low quality assets.

So what are some specific investment themes that could do well in 2011? Keeping it simple, an investor could just buy the S&P 500 or Dow Jones Industrials and probably do better than most other investments.

Getting more specific and somewhat more risky, buying undervalued sector ETFs like SPDR Select Financials, SPDR Select Technology and SDPR Select Utilities, beaten down country ETFs such as iShares Italy Index and iShares Japan Index, or out of favor bond ETFs such as iShares National Municipal Bond Index and iShares TIPS Bond index.

Sectors to avoid probably include precious metals, overheated emerging markets, small cap stocks, and illiquid or exotic bonds. The bottom line is that taking somewhat less risk and focusing on value will probably do better in 2011.

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