As the economy expands and contracts, so do the financial performances of companies across the 11 stock sectors. When the outlook is positive, economically sensitive companies perform better and investors are prompted to buy their shares. If the outlook turns sour, investors may sell out of those companies and swap into investments that can better weather economic downturns. This practice is known as sector rotation.
Sector rotation is evidenced in basic form by comparing the long and short-term performance of sensitive, cyclical, and defensive companies. Sensitive and cyclical stocks, which are more reactive to interest rates and other economic factors, have taken advantage of favorable conditions for most of the last decade.
In the three years since the start of the COVID-19 pandemic, however, spiking treasury rates, inflation, and a slew of Fed rate hikes have caused investors to rotate out of cyclical stocks. Large amounts of money flowed out of equities in general since the start of 2022, and though growth stocks are rebounding in 2023, they were more acutely affected last year. Value stocks, typically established companies with steadier business models, were investor safe havens.
The economy goes through cycles, and sector rotations occur at each stage. The most common cycles that investors follow are:
•Changes in the Market Cycle
•Changes in the Economic Cycle
•Overbought vs Oversold Cycles
The Market Cycle
The market cycle typically moves ahead of the economic cycle since investors make decisions in anticipation of the future. As such, the current market cycle stage can indicate which sectors will soon become market leaders:
This dynamic, in which the market cycle leads the economic cycle, came to fruition during both the 2008 and 2020 recessions. In 2008, the S&P 500 peaked months ahead of US Monthly Real GDP’s top. Stocks sold off in anticipation of a worsening economy.
When the COVID-19 pandemic struck in early 2020, the stock market was ahead of the 8-ball once again. Such is the nature of both stock prices that discount future cash flows, and investors who always want to be one step ahead.
More recently, equities began an extended downtrend at the very start of 2022, along with slightly negative GDP growth in the first half of the year. No official recession occurred in 2022, but as the probability of one continues to increase, investors will be watching out for equity declines as warnings of a possible economic contraction grow, even as stocks trend higher.
Layered underneath the market cycle is the economic cycle. Because economic data is released more infrequently, and investors price in their estimates beforehand, the economic cycle lags behind market movements. That said, it can provide solid confirmation of prevailing market trends. Sectors tend to perform differently based on the current economic cycle stage:
Lastly, overbought and oversold indicators can be used to hone in on investment decisions with added precision. A relative strength index (RSI) reading of 70 or higher indicates a security is overbought, and a value below 30 indicates it’s oversold. In April 2022, the value-focused Consumer Staples Select Sector SPDR ETF (XLP) triggered a common overbought signal when its RSI reached nearly 74. The ETF slid 12.3% in the one month following April 20th. Conversely, XLP rallied 15.7% in a span of 60 days after the RSI hit 23.7 on September 30th.
RSI readings coupled with 200-day simple moving average encounters can provide additional signals that a sector is overbought or oversold. Take for instance the growth-focused Consumer Discretionary Select Sector SPDR ETF (XLY)—XLY reached levels of resistance when the ETF rose to its 200-day SMA in both April and August of 2022. Investors promptly rotated out of XLY both times, and the sector most recently flashed signs of that same pattern at the end of January 2023, when it tested the 200-day SMA again. Incorporating technical indicators into sector rotation analysis is known by many as the “marriage of technicals and fundamentals.”
One argument for using a sector rotation strategy is that the share prices of companies within each sector tend to move in the same direction. This is a natural effect of sector classification, whereby companies with similar business models are grouped together. At a minimum, investors can gain baseline exposure to a given sector’s sensitivities using individual stocks. Or, broader exposure can be secured using sector ETFs.
An example is the relationship of crude oil prices with major airliners American Airlines (AAL), Delta Airlines (DAL), Southwest Airlines (LUV), and United Airlines (UAL), as well as United Parcel Service (UPS) and FedEx (FDX). Despite operating in different industries, these industrials sector companies all benefit from lower oil prices, causing share prices to move higher when fuel costs decline.
Investors use a top-down approach and look to macroeconomic indicators to assess the current economic cycle stage. Once favorable sectors are identified, rotations are made out of unfavorable ones and into those that are poised to grow.
Other Factors to Consider
Sector rotation involves active management, which requires frequent monitoring of market and economic events in order to capture opportunities. As explained earlier, the economic cycle takes longer to catch up to the market cycle—and markets could also fail to digest economic news efficiently. Mistiming the market cycle could cause alpha or returns to be left on the table.
Remember: rotating out of a given sector involves selling shares, and each profitable sale triggers a knock on the door from Uncle Sam to collect capital gains tax. Tax events can diminish overall returns, which is why the level of active portfolio management should be considered in order to avoid unnecessary capital gains tax.
Also keep in mind that industries aren’t as homogenous as broader sectors, and a deviation can throw off a rotation strategy. Using the previous example, low oil prices are a major tailwind for major airlines, but other industrials like railroads might suffer as crude oil shipments decline. It might be thought that a rising tide lifts all boats, but there could be outlying industries that fail to swim, reinforcing the need for thorough investment research such as a full top-down approach.
Finally, past performance isn’t always indicative of future results. Even if a chart historically shows declines after a security’s peak and growth following a trough, economic and market events could alter those trajectories.
Using YCharts to Plan Your Sector Rotation Strategy
Create custom presentation-view reports using Report Builder. Use the drag-and-drop tool to fill a presentation-style slide deck with Fundamental Charts, Comp Tables and more to illustrate sector rotation trends. All assets automatically update with the latest data, making for effortless creation of communication collateral.
Once you have a sense of current market conditions, it’s time to find investments that are poised to outperform. The YCharts Stock Screener finds securities across all sectors and industries based on your own criteria.
Tie your analysis together with Model Portfolios to validate your sector rotation strategy against any benchmark. Here you can evaluate how much alpha your rotation strategies drive, and showcase your research with client-ready PDF reports.
YCharts will let you know when a possible sector rotation is near with custom alerts. Get automatic alerts—and a head start on your sector rotation game plan—when an equity or economic indicator reaches certain levels, including price, moving averages, RSI, and much more.