Everything you need to know about sector rotation investing and how to do it within your own investment portfolio can be learned in a few short minutes. So, if you want to start a successful sector rotation strategy you only need two pieces of information:
- what stage of the economic cycle we are in,
- what stock sectors perform best in each economic stage of the cycle.
Sounds Simple, Right?
In theory it is, but in practice it requires some work. Thus, in the rest of this article we will explore some of the key concepts and issues you will need to know for sucess.
Sector Rotation Illustrated
Perhaps the easiest way to understand sector rotation is to see an illustrated chart. It shows each stage of the economic cycle, illustrating what the stock market is doing at that stage of the cycle and showing which stock sectors are expected to perform the best. In each stage of the economic cycle we can see exactly which stock sectors should perform best, which sector investment vehicles one can use, level of industrial production, consumer expectations, and what the interest rate yield curve looks like.
We need to observe these data points when approaching sector rotation with a fundamental analysis viewpoint. This will help us identify exactly what stage of the economic cycle we are facing. Sometimes the answer is not so clear and may not fit neatly into the box of what is expected. Of course, life can be a little messy sometimes and fundamental analysis is no different. The important takeaway point is to utilize the model to assess what should be happening, and to look at the other data points as signs or clues that the economic cycle may be changing.
The Basic Sector Rotation Model
There are four basic stages to a regular economic cycle, and within each stage of the cycle we have different levels and changes in industrial production, consumer confidence, interest rates, and Gross Domestic Production. To capitalize and profit on these expected changes that happen through a business cycle and investor can position their portfolio weightings more into the sectors that should benefit the most as the cycle shifts into the next economic phase.
Learning how to identify the stages of the economic cycle, and to sense when they are shifting is key for this strategy to work effectively. What makes this theoretical model a little more difficult to doin real life is that these economic indicators in the model are lagging indicators. The stock market is a leading indicator, meaning it anticipates these changes well in advance of them actually happening. So what is an investor to do?
Sector Rotation Analysis and Stages of the Stock Market
There are also four basic phases to the cycle of a stock market that we are interested in when trying to time the rotation of sectors. Within each stage of the stock market phase we have different economic activities and different market index directions, velocity of change, and momentum. Each phase of the stock market in this model is anticipating what will happen in the underlying economic cycle, and this is why we consider the stock market to be a leading indicator.
The general consensus is that the stock market anticipates economic events that are about 6 – 12 months into the future, and will start to respond to what it anticipates will happen 6 – 12 months before it actually occurs. In the context of sector rotation this means that one must be good at predicting or anticipating where the economic business cycle will be in 12 months time. Or be a patient investor and position portfolios well in advance of the actual changes.
The Stock Market Sectors
There are 11 basic sectors that categorize all stocks in the general stock market index. Nine of them are considered cyclical sector groupings, which means they are sensitive to the economic cycle and rise up and down at different points in the economic cycle. The two other common sectors are classified as defensive sectors and are not as sensitive to the economic environment, and generally provide a safer haven for investors when the economy is contracting.
Sector Rotation Funds
If sector rotation is so great, why not just invest in any of the available sector rotation funds? With over 10,000 mutual funds available to investors, many of these funds have created sector rotation style funds to allow investors exposure to this style of rotation investing. But how have sector rotation funds performed relative to the general market? How much are the fees and costs involved in owning a sector rotation fund? Are there minimum holding requirements and investment levels? There are many issues you need to consider before jumping into any of the sector rotation funds offered in the marketplace. In addition, several fund managers have created sector funds which will limit their active management within the specific sector or industry the fund specializes. These mutual fund sectors are more similar to ETFs yet still have some of the downsides of typical mutual funds.
Sector Rotation ETFs
How have sector rotation ETFs performed? One would think that with the structural cost advantages over mutual funds along with the flexibility of trading intraday like a stock these vehicles would have performed well? We would expect investment professionals at the helm of a sector rotation ETF to perform well. They should generally outperform the market indexes and similar sector rotation mutual funds due to their cost structure advantage. Another very popular option for investors practicing sector rotation is to focus on sector ETFs. Exchange Traded Funds have exploded in popularity due to their many advantages over mutual funds, and many practitioners of rotation investing also apply this model to more narrow industry funds.
Starting a DIY Sector Rotation Strategy
Here we put all the pieces of a sector rotation strategy together in an easy to follow step-by-step guide so any DIY investor can read the economic and fundamental clues occurring in the business cycle and position their own investment portfolio to benefit from sector rotation. Regardless of your investment knowledge or experience, after a little reading and research you should be able to follow this basic strategy. All you need to do is be able to read the clues of what the economy is doing and where it is going. Following these simple data points can be found in the daily business section of any newspaper.
Supercharged Sector Rotation Investing
One of the most common pitfalls of following a sector rotation investment style based on fundamental analysis of economic conditions is that getting the timing right is very difficult. Professional economists argue constantly over what stage of the cycle the economy is experiencing. They often have many different and conflicting predictions on where an economy is headed. If professional economists cannot even agree on interpreting these basic business cycles what hope does a DIY investor have? Luckily we have discovered a simple way to time the rotation underlying the economic cycle using leading indicators that anticipate the cycle rotation before it actually occurs.
The Best Sector to Invest in Now?
Now that we have reviewed all the key pieces of the sector rotation strategy, how do we know what sector to invest in today for the best investment return? If mutual fund managers struggle to do it, and Rotation ETF funds fare no better, how is a DIY investor supposed to figure out which sectors to invest within? Here we breakdown what an investor should look for, what important steps to follow, and what resources you will need. We also discuss a revolutionary method that is simple to follow and takes less than 10 minutes of your time per month.
Classic Rotation Chart of Business and Stock Market Cycles
The classic sector rotation chart (above) is a simple visual to see the economic cycle and to see how the stock market behaves during each phase of the cycle. More importantly, the Sector Rotation Chart also shows us which key sectors of the economy should benefit the most during that time of the economic cycle.
What is Sector Rotation?
Over the course of a regular business cycle each phase of it has different economic fundamentals which will affect sectors of the economy in different ways. Some sectors will thrive during a certain economic phase of the cycle, while others will struggle. Sector rotation is an investment strategy that takes advantage of these natural cycles by investing in specific sectors of the economy at times when they will perform best in the business cycle. As the cycle advances into its next economic phase, capital is rotated out of existing sector holdings into the next group of sectors expected to thrive in the new phase of the cycle. Sector rotation is the process of always investing capital is the strongest performing sectors of the economy.
The Stock Market is a Leading Indicator for Sector Rotation Strategies
This basic rotation chart really illustrates 2 separate cycles – the economic cycle, and the stock market cycle. The key takeaway point when comparing these two cycles is the fact that the stock market is a leading indicator and leads the business economic cycle by 6 – 12 months on average. The stock market tries to anticipate each new piece of economic information and respond to it. You can visually chart certain sectors on an interactive sector rotation chart to see which sectors perform during what stage of an economic cycle.
Another tool to see results is in Smartmoney’s Sector Tracker tool. In strong economic times with economic fundamentals that continue to grow the stock market responds favorably. When economic data is released that shows a slowing of economic growth, or economic data that does meet the expectations of the stock market it will usually respond in a negative fashion.
The Economic Cycle is Sometimes Hard to Pin Down
We need to observe several key economic data points when approaching sector rotation with a fundamental analysis viewpoint. This will help identify exactly what stage of the economic cycle we are facing. Sometimes the answer is not so clear and the data may not fit neatly into the segments of the sector rotation chart phases, and this leaves room for interpretation and shades of grey during these phase transition points. The important takeaway point is to utilize the model to assess what should be happening, and to look at the other data points as signs or clues that the economic cycle may be changing.
Classic Sector Rotation Model Using Fundamental Economic Analysis
This classic sector rotation model breaks the economic cycle down into 4 key stages we can observe. Within each stage of the cycle the economy is experiencing different rates of production growth, consumer expectations, interest rates, and yield curve shapes.
By analyzing these economic indicators and grouping them by what we expect to see in each business cycle stage we can use them as clues to identify what stage of the economic cycle we are facing, and more importantly which sectors we should invest in now.
4 Basic Stages to the Economic Cycle
There are four basic stages to a regular economic cycle. Within each stage of the cycle we have different levels and changes in industrial production, consumer confidence, interest rates, and Gross Domestic Production. Learning how to identify each stage of the economic cycle is critical to practicing the classic sector rotation model. Let’s explore each stage of the economic cycle now.
- Full Recession Stage. In this stage the economy is in full recession and economic contraction. Clear economic signals are evident to follow on a fundamental basis.
- Early Recovery Stage. In this stage the economy is starting its economic recovery and GDP is growing. Clear economic signals are evident to follow on a fundamental basis.
- Full Recovery Stage. In this stage the economy is in full recovery and economic growth. Clear economic signals are evident to follow on a fundamental basis.
- Early Recession Stage. In this stage the economy is entering a recession and economic contraction. Clear economic signals are evident to follow on a fundamental basis.
Analysis of the Stock Market Cycle
In the context of sector rotation analysis the stock market cycle can be broken down into 4 key stages. Within each stage of the stock market cycle the economy is experiencing different rates of production growth, consumer expectations, interest rates, and yield curve shapes. By analyzing these economic indicators and grouping them by what we expect to see in each business cycle, stage we can use them as clues to identify what stage of the economic cycle we are facing. And more importantly, which sectors we should invest in now.
4 Basic Stages to the Stock Market Cycle
There are four basic stages to a regular stock market cycle. Within each stage of the cycle we have different levels and changes in industrial production, consumer confidence, interest rates, and Gross Domestic Production. Learning how to identify each stage of the stock market cycle is critical to practicing sector rotation analysis. Let’s explore each stage of the stock market cycle now.
- Market Bottom Stage. In this stage the stock market is forming a bottom. Clear economic signals are evident to follow on a fundamental basis at this market cycle stage.
- Bull Market Stage. In this stage the stock market is forming a bull market. Clear economic signals are evident to follow on a fundamental basis at this market cycle stage.
- Market Top Stage. In this stage the stock market is nearing a top. Clear economic signals are evident to follow on a fundamental basis at this market cycle stage.
- Bear Market Stage. In this stage the stock market overall is declining. Clear economic signals are evident to follow on a fundamental basis at this market cycle stage.
Overview of the 11 Classic Stock Sectors
Each of the following stock sectors will behave differently in each of the business cycles and economic cycles we face. Let’s explore each of the 11 popular stock sectors now.
Cyclical / Consumer Discretionary
The Consumer Discretionary Sector includes companies from industries, such as media; retail (specialty, multi-line, Internet and catalog); hotels, restaurants and leisure; textiles, apparel and luxury goods; household durables; automobiles, auto components and distributors; leisure equipment and products, and diversified consumer services.
The Technology Sector includes companies from industries, such as computers and peripherals, software, diversified telecommunication services, communications equipment, semiconductor and semiconductor equipment, Internet software and services, information technology services, electronic equipment, instruments and components, wireless telecommunication services and office electronics.
The Telecommunications Sector includes companies in industry groups, such as fixed-line telecommunications and mobile telecommunications.
The Industrial Sector includes companies from industries such as aerospace and defense, building products, construction and engineering, electrical equipment, conglomerates, machinery, commercial services and supplies, air freight and logistics, airlines, marine, road and rail, and transportation infrastructure companies.
The Basic Industry Sector primarily consists of companies involved in such industries as chemicals, construction materials, containers and packaging, metals and mining, and paper and forest products.
The Energy Sector consists of companies that primarily develop and produce crude oil and natural gas, and provide drilling and other energy-related services.
The Staples Sector includes companies that are primarily involved in the development and production of consumer products that cover food and drug retailing, beverages, food products, tobacco, household products and personal products.
The Utilities Sector includes companies from industries, such as electric utilities, multi-utilities, independent power producers and energy traders, and gas utilities.
The Finance Sector includes companies from industries, such as diversified financial services, insurance, commercial banks, capital markets, real estate investment trusts (REITs), consumer finance, thrifts and mortgage finance, and real estate management and development.
The Index measures the performance of the healthcare sector of the United States equity market, and includes companies in industry groups, such as healthcare equipment and services, pharmaceuticals and biotechnology.
How Have Sector Rotation Funds Performed?
There are literally hundreds of specialty mutual funds available for investors. They allow you to focus in on tactical asset allocation and sector rotation strategies inside their investment portfolios. Jump onto any mutual fund screener to find some of these popular sector rotation funds, but you might want to do your research before you invest.
What we found was many of the sector rotation funds failed to outperform the market index over time, and had more than twice the expense fee costs of Exchange Traded Funds. If your considering a sector rotation fund you need to do your homework carefully.
DIY Sector Rotation Fund Investing
Why pay high fees, subject yourself to below average returns, and get boxed in with minimum holding periods and investment amounts? We are convinced that almost anyone can generate better returns than most of the professionally managed sector rotation funds. With a little research and a few hours per month, you can too. Our preferred investment vehicle is Sector ETFs. But with a little more homework and research you could still design an acceptable sector rotation strategy using sector mutual funds. So let’s explore some of the most popular sector fund providers now.
Fidelity Sector Rotation Funds
Fidelity offers a group of sector mutual funds that can be used as decent vehicles for sector rotation. Now there are still a few downsides to using these sector mutual funds over similar ETFs, namely the minimum holding periods, minimum investment amounts, short-term trading penalties, and higher expense ratios. You can check out Fidelity Sector Funds here. Pay close attention to hold periods, penalties, and expense fees when doing your investor homework.
Rydex Sector Rotation Funds
Rydex is another fund company that offers a selection of sector mutual funds. You can check out Rydex Sector Funds here. Rydex also carries a larger stable of sector ETFs which is another sound strategy to consider for sector rotation investing strategies.
How Have Sector Rotation ETF Funds Performed?
There are several specialty Exchange Traded Funds available for investors that want to focus in on tactical asset allocation and sector rotation strategies inside their investment portfolios. Jump onto any ETF screener to find some of these popular sector rotation ETFs. You might want to do your research before you invest. What we found was many of the sector rotation ETFs failed to outperform the market index over time. Plus, some had more than twice the expense fee costs of other Exchange Traded Funds. If your considering a sector rotation ETF you need to do your homework carefully.
Claymore/Zacks Sector Rotation ETF
Fidelity offers a group of sector mutual funds that can be used as decent vehicles for sector rotation. Now there are still a few downsides to using these sector mutual funds over similar ETFs, namely the minimum holding periods, minimum investment amounts, short-term trading penalties, and higher expense ratios. You can check out Zacks Sector Rotation ETF here. Pay close attention to expense fees and performance results when doing your investor homework.
Powershares Valueline Industry Rotation ETF
Powershares is another fund company that offers a sector ETF fund. You can check out Powershares Sector Rotation ETF here. Powershares also carries a larger stable of sector ETFs which is another sound strategy to consider for sector rotation investing strategies.
DIY Sector ETF Investing
Why pay high fees, subject yourself to below average returns, and get boxed in with minimum investment purchase amounts? We are convinced that almost anyone can generate better returns than most of the professionally managed sector rotation funds with a little research and a few hours per month. Our preferred investment vehicle is Sector ETFs, and with a little homework and research you could start a DIY sector rotation strategy.
Sector Rotation Strategy – A Guide for the DIY Investor
Here we put all the pieces of a sector rotation strategy together in an easy to follow guide. Any DIY investor can read the economic and fundamental clues occurring in the business cycle and position their own investment portfolio to benefit from sector rotation. Regardless of your investment knowledge or experience, you can too. All you need to do is be able to read the clues of what the economy is doing and where it is expected to go. Just follow simple data points that can be found in the daily business section of any newspaper.
Resources You Will Need
Like any DIY project you will need to gather the necessary resources to properly start a sector rotation strategy. So here is a list of what you will need:
- Computer and Internet connection
- Business section of a major city newspaper
- A brokerage account
- Stock Charting Program
Step 1 – Assess Consumer Expectations
What are consumer expectations doing right now? How do consumers feel about the economy and their economic livelihood? In good times consumers have disposable income to spend, feel good about their future economic prospects, and tend to spend money like it will always be there for them. This has the effect of driving higher GDP in the economy. Thus, reading a business newspaper like the Wall Street Journal will give you a pretty clear picture of consumer expectations.
Step 2 – Assess Industrial Production Levels
What level is industrial production at in relation to its business cycle? Is production at full capacity or is it idle? Businesses behave in a similar fashion to consumers about their business expectations – when times are good and business is expanding with strong profits they tend to spend more on expanding production and facilities. Conversely, when times are tough businesses pull back on spending, create layoffs, and reduce their expenditures. This has the effect of lowering GDP in the economy. Reading a business newspaper like the Wall Street Journal will give you a pretty clear picture of industrial production levels and their outlook.
Step 3 – Assess Interest Rate Trends
What are interest rates doing right now? How about the spread between short-term interest rates and long-term interest rates? And what is the trend in interest rate changes? Rising interest rates generally indicate a growing economy, and lowering interest rates generally indicate a cooling economy. The Wall Street Journal usually has a detailed section on interest rates. Often, they will chart their history so you can see what trend is developing.
Step 4 – Examine the Yield Curve
What is the slope of the yield curve which charts short term and long term interest rates? In a healthy economy the yield curve has a positive slope. Lenders are providing capital for longer periods of time expect a higher interest rate to account for the additional risk and time involved. Conversely, the yield curve can be inverted. At this point, short term rates are higher than long term rates. This implies that the bond market is predicting lower future interest rates and a possible recession. The Wall Street Journal or any other newspaper will usually have a graph of the current yield curve.
Step 5 – Determine the Current Stage of Business Cycle
Based on your observations in steps 1 – 4, use the Sector Rotation Model to determine which sectors are most likely to benefit in current business cycle environment.
Step 6 – Place your Sector Trades
Position your portfolio with some weighting to the sectors you have determined will benefit the most from the next stage of the economic cycle. Bear in mind that shifts between cycle phases can often be long and drawn out, with no clear distinguishing line to determine when one phase ends and another begins. Chances are your investment timing may be early, sometimes by many months, or it could be late. So it will all depend upon your ability to read the economic cycle clues, and the actual cycle transitions themselves. Some are long and drawn out, while others are so quick you can miss them.
Step 7 – Monitor Economic Signals and Repeat Steps 1 – 6 When Necessary
Successful sector rotation takes vigilance and constant monitoring of economic trends and statistics. As these business statistics change, they may be signaling that another cycle change is underway. You will need to read the business newspapers daily or weekly to stay on top of economic trends, as your sector investments are leading indicators and will be interpreting and responding daily to the unfolding economic news.
The Pitfalls and Downside of DIY Sector Rotation Based on Fundamental Analysis
If this is so easy why isn’t everyone doing it? Well in theory it sounds simple enough, but like most things in life once you try to implement them in real-world situations everything becomes much less clear. Real life will create situations that the model does not handle well, or it will take a lot longer to play out than anticipated. What if you are 12 months too early into the next rotation trade? Or what if you miss the trade by 5 months? Here are some of the pitfalls of using fundamental analysis as the basis for a sector rotation strategy:
Problem Determining Stage of Business Cycle
It’s often not clear what stage of the economic cycle we are in, and the transition from each phase of the cycle can take many months to unfold. Do you invest early, or wait for confirmation of sector movement before entering the trade?
Economic Signals Do Not Match Model
Sometimes the economic statistics and signals are false starts. Or the results do not match the theory of the sector rotation model. Thus, not everything will line up in neat and tidy rows to allow you to clearly determine a shift. In fact, its a running joke in economic circles that most economists cannot even agree on the interpretation of much of the published economic data.
Trading Sectors Too Early
There is a risk that you enter a sector trade much to early and expose your capital to losses. Or your capital sits idle for months or years while you wait for the sector trade to respond to the next phase of the economic cycle.
Trading Sectors Too Late
There is a risk that you miss the sector trade as the business cycle has shifted a lot faster than anticipated. But the sector indexes have already fully priced in the next cycle into their valuations.
It Takes a Lot of Time and Energy
Fundamental analysis of business and economic cycles takes constant monitoring and a lot of your time. In other words, if you miss following the economic data you may miss the signs of the next cycle.
How to Supercharge Your Sector Rotation Investing
One of the most common pitfalls of following a sector rotation investment style based on fundamental analysis of economic conditions is that getting the timing right can be very difficult. Even professional economists have many different and conflicting predictions on where an economy is headed. If professional economists cannot even agree on interpreting these basic business cycle statistics, what hope does a DIY investor have?
Study the Real Leading Indicators
We have flipped the process of sector rotation on its head and focus on studying what is actually happening. As most people know, the stock market is a leading indicator of where the economy is headed. Favored industries and sectors will see changes in their pricing 6 – 9 months before actual improvements in their fundamentals. We have found that focusing only on fundamental analysis of lagging economic data makes it virtually impossible to get the timing right on any sector trade. For this reason, we analyze the stock pricing changes of sectors and industry groups as the basis of our strategy.
Monitor Trend Changes in the 11 Key Sectors
Channel the focus of your sector rotation efforts on analysis of trends within the 11 key sectors of the economy. So what sector indexes are performing well right now? And how many are in an established uptrend? What is the strength of that trend? And what sectors are in a downtrend?
Rank the 11 Sectors in Descending Order of Strength
Now that you have done your basic trend analysis and ranked each sector in descending order of strength you have a list of investment prospects. The sectors at the top of your list are your best candidates. That’s because these are the sectors performing best at this current stage of the economic business cycle.
Repeat Ranking Process at Scheduled Intervals
It is important to repeat this ranking process at regularly scheduled intervals. Some of your current sector investments will drop in the ranking order. When this happens, replace them with new ones that have risen to the top of the list. Over time you will find that your portfolio is constantly invested within the top performing sectors of the economy. And you don’t have to spend so much of your time reading and monitoring economic data.
DIY Resources for Sector Rotation Investing
To effectively practice a Sector Rotation and Market Timing process on your own will require a commitment. You will invest time, discipline, thoughtful analysis, and access to stock charting software and a good stock data service. Plus, you should also take the time to read several books and articles. You should also read about technical analysis, fundamental analysis, and be prepared to be fluent in the programming language of your stock charting and analysis program.
A good software package is critical and will save you many hours of time per month. You will need stock analysis software programs that contain a programming language. This will allow you to tell it what to scan for in the markets. So here are a few of the leading programs out there:
Expect to spend 40 – 80 hours of your time learning the software and programming language for the market scanning features. In the first place, acquainting yourself with technical analysis, market timing, and sector rotation theory will usually require reading 5 or 6 of the key textbooks on this subject. Obviously, people with mathematical backgrounds will find this easier reading. Once you get going, expect to spend 10 – 12 hours per week to run your scans and analysis.
Newbies – expect to spend 500 – 750 hours per year (10 – 15 hours per week)
Investors – expect to spend 375 – 500 hours per year (7 – 10 hours per week)
Experts – expect to spend 250 – 700 hours per year (5 – 7 hours per week)
What is the cost of your time?
Even at minimum wage levels this time commitment will cost you anywhere from to $1,812 to $5,437 per year. But if you’re like most of our readers, your household income exceeds $100,000 annually. So, your time commitment is really worth somewhere between $12,820 and $38,461!
A DIY Approach to Sector Rotation Investing Requires a Big Investment of Time and Money
It is a big time commitment and will also require an annual budget of $1,000 – $3,000 depending on your selections. But the real cost for most people is the opportunity cost of time. So how much is 1 hour of your time worth? Now multiply that by 40 – 60 to get an idea of your monthly time commitment. Be sure you can afford to invest the required time on a regular and consistent basis. If not, you will not be able to sustain a successful market timing sector rotation strategy.