Sector rotation theory and research into market cycles have been around for over 200 years. Learn how to implement sector rotation in your own stock portfolio.
What is Sector Rotation?
The investing strategy of sector rotation is based on the principle that some industries will benefit more during different periods of the economic cycle than others. Mutual funds and managers of large portfolios practice sector rotation to attempt to outperform the stock market and reduce risk.
To effectively implement a sector rotation strategy, we need to understand that the economic cycle is split into four stages:
4 Stages of Sector Rotation
Early recovery occurs after a recession. During the early stages of recovery from a downturn, you may see that transportation companies are seeing more profits, and they are starting to move around more products to market. Auto manufacturers who have been crushed to near bankruptcy are recovering. The industrial sector starts to pick up. As growth begins to emerge from the ruins, good sectors to potentially invest in are recruitment and improving industrial conglomerates that have avoided bankruptcy and are undervalued by the market.
Late Recovery (Boom)
During this period, the world is an excellent place for stocks, the consumer is in buying mode, and consumer durables and technology are doing well. Retailers (online and offline) are seeing huge demand, and lending is increasing. New start-ups, new fledgling industries tend to do very well during this period.
Growth is starting to slow down, and the pace of expansion cannot continue. The move to more secure investment categories starts to happen. Bonds come back into favor, and the business sectors that may see improved performance are utilities (water, gas, electricity) and specific cyclical industries.
Full Recession (Bust)
In a full recession, the economy is bad, unemployment is higher, and interest rates are reduced to stimulate growth. During the bust, it is best not to be in stocks. But if you feel you must, good sectors are those that provide the goods and services people cannot live without, such as food, heating, energy, health. Precious metals such as gold or silver tend to do well during this economic cycle.
Does Sector Rotation Work?
No, sector rotation is not proven to out-perform the stock market averages. Sector rotation can provide some shielding against the economic ups and downs. If done correctly, it can reduce risk and increase profits. Unfortunately, there is scant evidence that sector rotation can be consistently implemented to produce outsize market-beating returns for investors.
To use sector rotation to your advantage, you need to deeply understand economics and have a good grasp of where the economy is in the business cycle; even top economists struggle with this.
Even if you practice sector rotation, it does not mean it will be successful or select the best company or vehicles to invest in.
Sector Rotation Duration
The duration of each stage of the economic cycle depends on the state of the economy. There are two key theories on cycles that can affect sector rotation.
Clement Juglar was one of the first to develop an economic theory of business cycles. The Juglar Cycle is approximately 9.2 years, fluctuating between 7 and 11 years. This highlights the concept of nominality, meaning each larger wave detected seems to be twice the size of the next smaller wave. The Juglar Cycle is of a similar wavelength to the 10-year “stock market cycle.”
On average, the length of each sector rotation would be from 2 to 2.5 years.
The Effort to Maintain a Sector Rotation Strategy
Regularly evaluating the economic situation and having a good grasp of all tools and companies can be time-consuming. Plus, you will need to assess and rotate out of each stock and rotate into more favorable stocks.
Performing a Sector Analysis
Big money circulates through different sectors. For example, if the news is announced that the U.S. or China is to invest heavily in green energy over the next few years, the market participants will seek to invest in this area as the companies in the energy sector will seek additional revenues because of the investments. So you may see a surge in investment in the sectors or ETFs (Exchange Traded Funds) that contain those types of companies; for Solar Panel Manufacturers, the ETF (Ticker: GRNSOLAR); or for Wind Energy the ETF (Ticker: GRNWIND).
Finding Winning Stocks in Winning Industry Sectors
Investing in a sector that is experiencing a high influx of capital can be a good investment decision. You need to follow this process.
- Is the stock market moving upwards? Perform a market analysis.
- What are the leading industry sectors? Perform a sector analysis.
- What are the leading companies in those sectors?
- Research the companies in the leading sectors.
How Are Industry Sectors Defined?
There are many types of Industrial Classification systems to pigeon-hole businesses into a certain classification, such as the Standard Industrial Classification (SIC), International Standard Industrial Classification (ISIC), or the Global Industry Classification Standard (GICS) created by Morgan Stanley and Standard & Poors. They are all designed to achieve more or less the same goal.
The Best Software For Sector Rotation
When selecting the software for a sector rotation strategy, it will need to provide the following functionality.
- Easily perform research of industries, sectors, and stocks.
- Provide powerful financial and fundamental screeners across all sectors.
- Provide comparisons of companies in the same sector and industry.
- Enable easy portfolio management and rebalancing.
- Connect to your broker to perform detailed portfolio correlation and analytics.
Out of our Top 10 Stock Market Analysis Software Review, only one program fulfills these criteria. Stock Rover is the leading Stock Research, Screening, and Portfolio Management tool on the market today and the service I use every day.