Should you use a Sector Rotation Strategy?
If you watch the nightly news, read investment blogs and listen to market channels you will have no doubt heard something along the lines of “We’re seeing a classic sector rotation in the market today”. But what exactly is Sector Rotation? Does it really work, and how can I use it to my advantage. In this edition, we’ll tackle these questions and discuss how you can incorporate sector rotation in your trading strategy.
What is Sector Rotation?
Somewhat of a buzz phrase, sector rotation is simply the transition of money invested from one industry to another as investors take advantage of cyclical trends in the overall economy.
As market analysts have noticed, the economy moves in a somewhat predictable fashion. It is always moving, cycling in and out, from boom to bust, peak from trough, and back again. This has spurred an investment strategy that anticipates this movement by preemptively moving investments across the business sectors that have historically performed best in the next business cycle.
The theory goes that when you group stocks according to their industries or sectors, they have distinct sensitivities that affect profitability. These sensitivities align better with different stages of the business cycles. Knowing which stage of the business cycle can help investors position themselves in profitable sectors while avoiding the wrong ones.
Since sector rotation analysis attempts to understand the relationship between a) investment sectors with b) the stock market cycle and c) the general business cycle, we take a closer look at each of these elements below.
What are the 11 investment sectors?
It seems like all anyone wants to talk about these days are ‘tech’ stocks. The extraordinary success of the likes #AMZN, #MSFT, #TSLA, and #AAPL have certainly catapulted tech to the forefront of all investors and trader’s portfolios. So much so that in the last decade, there has been a dramatic shift to more technology-based stocks. Excluding Facebook and Alphabet which are now classified as ‘communications services’, tech companies account for more than 25% of those in the S&P 500, and the tech sector has seen a 300% upside since 2010.
But let’s not forget the Global Industry Classification Standard (GICS®) structure includes 10 other investment sectors representing key areas of the economy. Each sector rolls in and out of popularity and have their own set of unique dynamics that affect profitability. We take a look at the 11 investment sectors below.
- Includes oil, gas & power companies and refineries
- Sensitive to the price of crude oil, natural gas, and other commodities
- Most Popular ETFs — Energy Select Sector SPDR Fund (XLE)
- Includes companies that involved in discovering and developing raw materials. Such as mining, refining, chemical, and forestry.
- These companies are at the beginning of the supply chain so are sensitive to the business cycle.
- Most Popular ETFs — Materials Select Sector SPDR Fund (basic materials) (XLB)
- Includes aerospace, machinery, defense, construction, and manufacturing companies.
- Growth in the industry is linked to demand for building and agricultural equipment.
- Most Popular ETFs: Industrial Select Sector SPDR Fund (industrials) (XLI)
- Involves media, consumer service providers, apparel, and clothing companies.
- Growth linked to a healthy economy as consumer spending accelerates.
- Most Popular ETFs: Consumer Discretionary Select Sector SPDR Fund (XLY)
- Includes Mostly food and beverage companies.
- Defensive investment as these companies can generally survive economic downturns as consumers are unwilling to cut these products from their budgets.
- Most Popular ETFs: Consumer Staples Select Sector SPDR Fund (XLP)
- Includes biotechnology companies, medical device manufacturers, and hospital management firms.
- Considered a safe investment as people will always require medical assistance.
- Most Popular ETFs: Health Care Select Sector SPDR Fund (XLV)
- Includes banks, investment funds, real estate firms and insurance companies.
- Sensitive to changes in interest rates as the majority of revenue stems from mortgages and loans.
- Most Popular ETFs: Financial Select Sector SPDR Fund (XLF)
- Includes electronic manufacturers, IT firms, and software developers.
- Robust growth tied to the general health of the economy.
- Most Popular ETFs: Technology Select Sector SPDR Fund (XLK)
- Includes wireless providers, cable and internet service providers, and satellite companies.
- The main source of revenue is from recurring consumers.
- Most popular ETFs — Vanguard Telecom ETF (VOX A+) & iShares US Telecommunications ETF (IYZ)
- Includes electric, gas, and water providers.
- Defensive play as the sector generates consistent revenue from consumers.
- Most Popular ETFs: Utilities Select Sector SPDR Fund (XLU)
- Includes companies invested in residential, industrial, and retail real estate.
- Sensitive to interest rate changes as the main source of revenue comes from rental income and capital appreciation.
- Most popular ETFs — Vanguard REIT ETF (VNQ A+) & iShares U.S. Real Estate ETF (IYR)
The Four Stages of the Market Cycle
When we refer to market cycles, we’re talking about the shifts in the business environment that lead to noticeable patterns in the stock market. As discussed above, certain sectors are heavily influenced by market factors such as interest rates and consumer spending. These sectors have historically performed better at certain stages of the market cycle that present the conditions needed for growth.
While it is difficult to pinpoint the beginning and the end of the market cycle, changes in the regulatory environment, advancements in technology, new products, and natural disasters can spark changes in the business environment that result in turning the market cycle. Each cycle goes through the same pattern of rising in the beginning, peaking at the top, then the inevitable dip and bottom out at the end. The end of one cycle is the beginning of the next cycle.
The market cycles tend to move ahead of the business/economic cycle. This is because investors look at future earnings, growth & potential when investing in stocks. Even in the pits of recession, the market anticipates recovery as there is always high hope that the economy will bounce back.
There are four stages of the market cycle — accumulation, mark-up, distribution, and downtrend. We take a closer look at these four stages below.
The first stage of every market cycle is the accumulation phase. It begins after the market has already reached its long-term bottom in the previous cycle and stock valuations are low. This represents a prime time for investors to buy as trend reversal is near. As smart money continues to invest in undervalued assets, the downtrend begins to lose momentum.
The mark-up phase continues on from accumulation and shows market consolidation. The market begins to rally and attracts more buyers who want to take advantage of the new upward trend. The buying pressure continues to push stock prices even higher. As prices will start to form higher highs and higher lows, traders will normally look to these small pullbacks as signs to enter the market.
In the distribution phase, the market will reach its peak. This is characterized by less higher highs and the slowing down of buying momentum as it becomes more neutral. As there is normally an equal amount of buyers and sellers in the market, stocks are often stuck in a trading range for long periods of time. As stock prices and valuations are at their peak, this is the time to sell before market sentiment turns bearish.
The final stage downtrend occurs and the market comes tumbling down. As market sentiment turns bearish, investors and traders begin to sell to lock in their profits. This increase in selling pressure sparks a downward trend as more investors follow suit. This stage is marked by lower lows and lower highs.
The Four Stages of the Business Cycle
Along with the market cycle, there is a business/economic cycle that tends to trail the market cycle by a few months. The business cycle represents the fluctuations of the economy between growth and recession. Each stage of the cycle is characterized by factors such as interest rates, gross domestic product, employment rates, and consumer spending.
Since the 1950s, business cycles in the U.S have typically lasted an average of 5.5 years. However, in saying that, business cycles do not occur at regular intervals and there are wide variations in the length of business cycles. The peak to peak cycle of 1981–1982 lasted a mere 18 months while the record expansion from June 2009 to February 2020 lasted well over 10 and a half years.
The four stages of the business cycle are expansion, peak, contraction, and trough. We discuss them below.
The first stage of the business cycle represents the initial phase of recovery from the recession. The economy starts to grow as consumer expectations begin to rise and economic output increases.
Characteristics of this stage include GDP growth rate returning back to a healthy rate of 2–3%. Unemployment sitting at its natural rate of 3.4–4.5%. Inflation is near its 2% target and interest rates have bottomed.
Historically, the industrials and materials sectors tend to be very successful during this stage as industrial production increases. Financials, real estate, consumer discretionary, and tech sectors are also historically profitable during this stage.
The expansion stage is followed by the peak. This represents the later stage of recovery when the economy starts to overheat as investors are in a state of ‘irrational exuberance’.
Characteristics of this stage include GDP growth rate greater than 3% and inflation greater than 2%. A rapid rise in interest rates while consumer expectations begin to decline and industrial production bottoms out.
Historically, the technology, consumer staples, and telecommunication services sectors tend to be profitable during the peak stage.
The peak is followed by contraction as economic outlook weakens. Contraction is the beginning stage of a recession and consumer expectations decline.
Characteristics of this stage include GDP growth rate falling below 2%. Unemployment is on the rise as companies effect massive layoffs. Interest rates are at their highest and industrial production is falling.
Historically, utilities, materials, consumer staples, health care, and energy sectors tend to remain profitable during contraction.
During the trough phase, the economy hits bottom and begins its transition back to the start of the cycle, back to expansion.
As the economy is in the midst of a full recession, consumer expectations are at their all-time low. GDP growth is in the negative, interest rates are falling, and its a difficult time for job seekers and businesses.
During these difficult times, consumer staples, health care, and utilities tend to do well.
Should you consider a sector rotation strategy?
A Sector Rotation Strategy involves traders and investors anticipating which companies will be successful in the coming stage of an economic cycle. By watching for signs of a future change in the business cycle, investors can rebalance and optimally position their portfolios. All this is logical in theory however there are a number of risk factors associated with sector rotation strategies.
Risk factor — Difficulty in recognizing sector rotation
Recognizing changes in the business cycle is much harder to do in real-time. The telltale signs investors can look to such GDP growth, interest rates, inflation, the success of government fiscal policies are much easier to spot in hindsight. Even the National Bureau of Economic Research has a history of announcing recession trough a year after it has happened. For example, the June 2009 trough recession date was announced on 20 September 2010.
Risk factor — Sectors can defy expectations
Not only do you need to correctly guess the timing of the sector rotation, but you also need to accurately pick the top-performing sectors. While investors can look to sectors that have historically outperformed, past performance is never a guarantee of future performance. Entire industries can adapt and fix what was wrong or antiquated. Old companies that once dominated a sector can be replaced by entirely new drivers that do things differently. This can defy traditional investor expectations.
Risk factor — Sector Rotation Strategy costs money
Every time you buy and sell and move your holdings from one sector to another, you will be charged transaction fees. This may not be a big deal in the age of discount brokers. However, trading fees and commissions can quickly add up and eat away at your profits.
A deeper understanding of the different stages of the market and business cycles can give investors and traders a theoretical leg up over others in the market. When you learn to recognize the transitions between cycles, you can preemptively shuffle around your investments to take advantage of the next stage of the business cycle. However, recognizing these sector transitions are notoriously difficult to do in reality.
A 2008 study into the validity of a sector rotation strategy found that:
“Even with perfect foresight and ignoring transaction costs, sector rotation generates at best 2.3% annual outperformance from 1948–2007”
At the end of the day, there is no replacement for a diversified portfolio and good chart analysis. By diversifying your assets you can avoid being caught off-guard by a sector rotation and still prosper even when the market goes down.