The Basics of Sector Rotation

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The stock market is a dynamic entity. It lives and breathes like an organic being, but instead of oxygen and water, it feeds off of the business cycle. Certain sectors outperform or under-perform depending on where the business cycle is at which gives investors an opportunity to profit by following along.

One of the most common investment strategies is known as sector rotation. Stocks are bought and sold as certain sectors move in and out of favor correlating with the business cycle. Regardless of what stage the economy is in, there are always certain sectors that stand out as being clear winners while others typically lag behind and should be avoided.

For investors, following the business cycle eliminates some of the guesswork involved in investing and can help mitigate risks in their portfolio.

The business cycle and the market

The business cycle is what economist call the change the economy goes through over time. It happens in several stages: early cycle, mid-cycle, late cycle, and recession. For each stage, certain sectors of the economy benefit more than others making it a good baseline for portfolio design. Below is a breakdown of each stage and what sectors outperform or under-perform:

Early-cycle phase: This phase is marked by economic recovery, usually from a recessionary phase with economic growth turning positive. Monetary policy eases and credit becomes lighter. Business sales growth rises while inventories are generally low. Sectors that outperform during this phase include consumer discretionary, technology, and industrials. Under-performers include energy, telecommunications, utilities, and consumer staples.

Mid-cycle phase: The mid-cycle phase is usually the longest phase of the economic cycle and is defined by consistent economic growth while business inventories and sales reach an equilibrium. This phase doesn’t have many clear winners or losers but technology and industrials seem to perform better than most while materials historically lags.

Late-cycle phase: In this stage of the business cycle economic activity can be described as “overheating” with high inflation and tighter monetary policies aimed at restricting growth. Materials, energy, and healthcare are the best performing sectors while consumer discretionary and technology tend to lag the most during this phase.

Recession phase: The recession phase is arguably the easiest to identify as economic activity turns negative while credit becomes difficult to procure and business profits fall. Sales growth stagnates while businesses burn off high inventories in anticipation of a turnaround. Sectors that benefit during a recession are consumer staples, healthcare, telecommunications, and utilities. Industries to avoid include technology, industrials, and materials.

Final considerations

One of the oldest investment strategies “buy and hold” seems to fly in the face of sector rotation since stocks are held over a long period of time regardless of what stage the economy is in. There are several competing theories that favor one strategy over the other, but ultimately it comes down to investor preference. If you have the time and ability to dedicate to your investment portfolio, sector rotation may be something to consider. However, if you don’t have that kind of time and you have a long-term investment horizon (a decade or longer), then buy and hold may be a better choice.