What Is Sector Rotation? How It Works and Importance in Investing

What Is Sector Rotation?

Sector rotation is the movement of money invested in stocks from one industry to another as investors and traders anticipate the next stage of the economic cycle.

The economy moves in reasonably predictable cycles. Most industries and the companies that dominate them thrive or languish depending on the cycle.

That plain fact has spawned an investment strategy based on sector rotation. Even investors who don’t base their entire strategy on sector rotation would be wise to anticipate the cycle.

Key Takeaways

• The economy moves in a predictable cycle from boom to bust and back again.
• Many sectors tend to perform better in one stage of the cycle than in others.
• Stock investors try to anticipate the next cycle months in advance. They move their money into the industries that tend to perform best in the next cycle.

Understanding Sector Rotation

Sector rotation emerged as a theory from the analysis of data from the National Bureau of Economic Research (NBER) demonstrating that economic cycles have been fairly consistent since at least 1854.

Thanks to the work of government and academic economists, we know the approximate start, duration, and end of every past business cycle since the middle of the 19th century.

Spotting changes in the cycle is harder to do in real time. The NBER has been known to announce that a recession has ended more than a year after the fact.

That’s not much help to an investor trying to take advantage of the end of one cycle and the start of the next. Luckily, other signs can help investors determine where their money should be invested to take advantage of sector rotation.

The Market Cycle

The stock markets don’t move with the economic cycle. They move in anticipation of the economic cycle, or at least they try to. The market cycle can be divided into four stages:

• Market bottom: A long-term low point is reached.
• Bull market: The market rallies from the market bottom.
• Market top: The bull market starts to flatten out.
• Bear market: Here we go down again. This is the precursor to the next market bottom.

Most of the time, financial markets attempt to predict the state of the economy from three to six months into the future. That means the market cycle is usually well ahead of the economic cycle.

This is crucial for investors to remember because the market will always start to look ahead to recovery while the economy is in the pits of a recession.

Important

We know the start, middle, and end of every economic cycle since the mid-1800s. Predicting the next one is harder.

The Economic Cycle in Four Stages

Below are the four stages of an economic cycle, along with some of the sectors that tend to thrive at each stage. Keep in mind that these usually trail the market cycle by a few months.

Full Recession

Gross domestic product (GDP) is retracting quarter-over-quarter. Interest rates are falling. Consumer expectations have hit bottom. The yield curve is normal. Nevertheless, some sectors continue to perform well:

• Cyclicals and transports (near the beginning)
• Technology
• Industrials (near the end)

Early Recovery

Things are starting to pick up. Consumer expectations are rising. Industrial production is growing. Interest rates have bottomed out, and the yield curve is beginning to get steeper. Historically, successful sectors at this stage include:

• Industrials (near the beginning)
• Basic materials
• Energy (near the end)

Late Recovery

Interest rates may be rising rapidly, and the yield curve is flattening. Consumer expectations are beginning to decline, and industrial production is flat. Historically profitable sectors in this stage include:

• Energy (near the beginning)
• Consumer staples
• Services (near the end)

Early Recession

The overall economy looks bad. Consumer expectations are at their worst. Industrial production is falling. Interest rates are at their highest, and the yield curve is flat or even inverted. Historically, the following sectors have found favor during these rough times:

• Services (near the beginning)
• Utilities
• Cyclicals and transports (near the end)

What Are the 11 Stock Sectors?

Eleven key industry sectors make up the U.S. economy. They are:

• Communication services
• Consumer discretionary
• Consumer staples
• Energy
• Financials
• Healthcare
• Industrials
• Information technology
• Materials
• Real estate
• Utilities

There are 163 subsectors within these sectors.

How Do I Know Where to Move My Money Depending on the Economic Cycle?

The thinking behind sector rotation is logical. In a recession, consumer staples like cereal and soap continue to sell because everyone still needs them. They may switch to cheaper cereal or soap but they’ll still buy them. Consumer discretionary products will suffer. These are big-ticket items like cars and dishwashers that people will put off buying during a recession.

Can I Use Exchange-Traded Funds (ETFs) in a Sector Rotation Strategy?

Yes, there are many exchange-traded funds (ETFs) and mutual funds that focus on specific sectors of the economy.

Sector rotation, whether you’re using ETFs or individual stocks, is an active, not passive, investment strategy. You have to stay on top of anticipated changes in the economic cycle to be ready to move your money in time to beat the cycle.

The Bottom Line

With this pattern in mind, traders try to anticipate which companies will be successful in the coming stage of an economic cycle. Equally important can be the signs the market is exhibiting regarding future economic conditions.

Watching for the telltale signs can give you insight into which stage traders believe the economy is in. They may be right or wrong, but they’re acting on their belief.

Read the original article on Investopedia.