Sector Rotation Theory

One method of asset allocation is to engage in sector rotation. This is a strategy that takes advantage of how different industry groups respond to business cycles. It is recommended to avoid young, small-cap firms and focus on large blue-chip firms.

The sectors are broken down into 8 core groups: Basic Materials, Consumer Cyclical, Consumer NonCyclical, Energy, Financial, Industrial, Technology and Utilities. This method of dispersion breaks into 77 different industries. a bit different than the traditional method used by Barron’s.

There are 3 key business cycles: the corporate profit cycle, the credit cycle, and the inventory cycle.

These business cycles are then divided into 4 phases, and each sector responds differently to each phase.

Phase 1 starts at the bottom of a recession when GDP is still negative. However, the leading indicators have been looking positive, people are still employed, families are beginning to purchase more, and there is overall growth in consumer confidence. Production picks up and prices become steady. Consumer cyclicals (clothing, automobiles, home construction, entertainment) do well as consumers begin making purchases beyond what their necessities are. Energy also does well as production picks up and demand for energy needs increase.

Phase 2 is marked by an overheating economy. The Federal Reserve engages in monetary policy and increase interest rates. Interest-sensitive industries (utilities and financials) do not do well during this phase, as they are more affected by rate increases than other sectors. The bond market also doesn’t do well during this time. Higher interest rates also affect consumer purchases, and discourage consumers from buying big items, such as automobiles and houses. Technology stocks and Basic Materials do well in this phase. Efficiency is emphasized as production reaches full capacity.

Phase 3 begins with a decrease in the rate of GDP growth, as the interest rate hikes finally do what they were supposed to do and slow the economy down. The industrial sector thrives as transport industries do well. Interest rates stabilize which helps financials achieve solid economic performance as well.

Phase 4 is a steep decline in growth rate, much larger than the decrease seen in Phase 3. The Fed begins decreasing the interest rate in hopes to stimulate the economy. Utility services and consumer noncyclicals are relatively inelastic, so they are unaffected by the turmoil during this phase, and perform the best.

Overall, the movement in interest rates is the best indicator to determine which phase of the cycle that we are in. We can look at the second interest rate increase as a transition from phase 1 to phase 2, and the second rate cut as an indication of movement to phase 4. Phase 1 and 3 are a bit harder to pinpoint, as the Fed doesn’t engage with interest rates during these phases. It is also important to note which stocks are performing well to determine which phase we are in.

Business cycles never occur for a set amount of time, and neither do the phases. All the movement is variable, and dependent on economic activity. Changes in corporate profit, the credit cycle, and the inventory cycle, as mentioned earlier, all effect how the business cycle moves.

One way to engage in sector rotation is to have all your stocks in industries defined by the phases. This means a lot of turnover as the phases change. You can also take a more conservative approach, and have half your stocks in the current phase, and the other half in the next phase. So when you buy again, you would buy two phases ahead. It’s less turnover.

However, it can be hard to pinpoint which phase we are in. Also, the Fed has become better at reducing the highs and lows of the business cycle, meaning there is less amplitude on the sine wave. This can hurt investors’ opportunity to engage in sector rotation, as the phases melt into one big phase.

There are also global risks and inflation overlay to keep in mind. These can both hurt industry profitability. That is why it is important to engage in macro-fundamental analysis.

Overall, sector rotation offers an interesting option to investors looking to engage in a more active strategy. It allows for response to the market conditions, rather than the infamous “buy-and-hold” method