There are several decisions that must be made prior to entering a trade or investment. One must first decide what to invest in. Then the choice of when to invest comes and finally where to exactly enter. Most people decide what to invest in due to a recommendation from a broker, a friend, or even from television or print media. Any casual observer of the stock market can easily see that the stock market goes through a cycle of bullish and bearish movements. What many do not know is that there is also a cycle with sectors that also go through these same movements.
What you need to realize about the markets is that roughly 50-60% of a stock’s move is directly related to the movement of the broad market. There are exceptions, but as the saying goes, a high tide will raise all boats in the marina. This means that in a bullish market, most stocks will rise, and they will similarly fall in a bearish one.
There will be different participation in these bullish or bearish markets depending on the sector the stocks belong to. The sector movement and trend can influence up to 30-40% of a stock’s movement. That only leaves about 10-20% of the movement attributed to the company’s fortunes itself.
What is Sector Rotation?
Sector rotation is an investment strategy that tracks sectors of the market (stocks of companies in similar industries) that typically perform in unison. Traders use the knowledge of which sectors show gains as others show losses to plan their trading activity. It is a strategy for investing to get better returns than the broad market and a method of market analysis to identify what phase the market is in and where it may be headed.
When you rotate the stocks you are investing and trading in, you are moving money out of stocks in the sectors that are underperforming for ones in sectors that are doing better. Certain sectors and sectors in general perform better depending on the state of the economy. By putting your money into the better performing sectors, you could get much better returns than keeping it in one place or in the broad market ETFs or index itself.
As an analysis technique, following the sector rotation model looks to see which sectors are performing the best and, based on normal patterns and cycles, predicts the health and direction of the economy. While it cannot be used exclusively to time the market, it is one piece of evidence that could be used.
Trading with the Sector Rotation Model
When we are selecting trades or even long-term investments, we want to be diversified but also invest with focus and purpose. We should start with a top down approach where we analyze the markets first and determine the most probable trend direction.
Once that is done, then the focus changes to choose the sector or sectors that are likely to move the best in that market environment. As mentioned earlier, the stock market follows a sector rotation model that can be used both to identify opportunities in the markets as well as letting us know where we are in the economic cycle. As seen below in the figure from John Murphy’s www.stockcharts.com website, sectors in the stock market outperform the broad market in different economic cycles.
You may notice that the stock market cycle seems to lead the economic cycle. This is because people and institutions speculate in the market on what the companies and the economy will do in the future, therefore the market naturally leads the economic cycle.
What stocks are good investments in a bear market?
When the markets have been beaten down in a bear market, institutions will look to buy cheap stock in sectors that are set to perform well when the economy turns upward. These sectors include consumer cyclicals, technology and industrials.
What stocks are good investments in a bull market?
Cyclical stocks represent companies whose products are purchased when the public has extra money to spend. When the economy is picking up, there will be new jobs created as well as raises in pay. This will cause increased spending in these and even luxury items. Technology will also expand and become higher in demand. People can afford to buy these products when fully employed. The industrial stocks will rise with an increase in production of all these goods. This is where we seem to be currently.
As the markets are in a full bullish swing, there will be a high demand for materials to produce goods. This leads to an increase in prices for those materials and in inflation. The material producers benefit initially from this increase. Another sign of inflation is the high cost of energy. When energy producers are leading the markets, the Federal Reserve may be forced to step in and raise interest rates to curb inflation. This is what the markets looked like when they peaked in 2007.
Once the stock market begins to stall, then money will flow out of the cyclical stocks in a flight to safety. This safe investment can be found in consumer staples. These are companies that produce everyday items we consistently use. Toiletries, alcohol, tobacco and even auto part stores will be valued as people will try to keep older cars functioning rather than buy new ones if their job is in jeopardy.
Additionally, healthcare is something that people do not want to do without. This industry will general outperform when the markets are starting to decline. As the market continues to drop, the economy will also start to show weakness. The Federal Reserve will eventually step in and cut interest rates.
The lower interest rate environment favors the utility sector and the financial sector for two related reasons. Utility companies operate with high debt levels. When the interest rates drop, these utility companies can recall their outstanding bonds and issue new ones at lower rates to improve their operations. Low interest rates also attract borrowing from companies which allows them to expand operations. This benefits the financial sector who make money from lending services.
Using The Stock Market Sector Rotation
The cycle will repeat itself over and over again as the consumer cyclicals will again be on everyone’s radar before the economy climbs.
We can see this phenomenon in the below chart based on the bearish market in 2008. Realize, that while the chart looks like you could have made money in the bearish market by buying the bearish sectors, this is not entirely true. The charts are showing the sectors versus the S&P 500 index. If we remove the index comparison, you can see that you would have lost money in nearly any position during the crash.
Knowing what to trade is valuable. We can utilize the sector rotation model when selecting the sector we wish to invest in. To learn more about how to select the correct investment or trade, come visit us at your local Online Trading Academy center today.