Your Complete Guide to Sector Rotation
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, prompting investors to buy their shares. If the outlook turns sour, investors may sell out of those companies and swap into ones that can better weather economic downturns. This practice is known as sector rotation.
Sector rotation is evidenced in its most basic form by the 10-year performances of value and growth companies. Growth stocks, which are more sensitive to interest rates and other economic factors, took advantage of favorable conditions across the decade and drastically outperformed value.
However, spiking treasury rates and inflation in Q1 2021 caused investors to rotate into value stocks, typically companies with steadier business models. Value outperformed growth in light of the economic backdrop as rotations were made in droves, given the higher volume of shares that traded hands.
Cycles that Trigger Sector Rotations
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
• Oversold vs Overbought Cycles
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:
Best Performing Sectors
Systematic risk resulting from a poor economic backdrop brings the whole market lower. Investors prepare to rotate into more economically sensitive sectors.
The market bottom has passed, and the worst is over. As economic activity picks back up, so do share prices of cyclical stocks.
Economic growth overheats, and interest rates rise. Investors prepare to rotate into more "defensive" sectors that are less economically sensitive.
Communication Services Financials
Markets begin to drift from highs, and economic activity slows. As investors rotate out of cyclical sectors into defensive ones, selling activity accelerates the market decline.
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 COVID-19 became a pandemic 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.
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:
Best Performing Sectors
Falling GDP, Falling Production
Pessimistic Consumer Sentiment
Falling Interest Rates
Normal Yield Curve
Rebounding GDP, Increased Production
Optimistic Consumer Sentiment
Low but Stable Interest Rates
Steepening Yield Curve
Consumer Discretionary Industrials
Tapering GDP, Tapering Production
Strong Consumer Sentiment
Spiking Interest Rates
Flattening Yield Curve
Consumer Discretionary Energy
Declining GDP, Declining Production
Weakening Consumer Sentiment
Tapering Interest Rates
Flat or Inverted Yield Curve
Communication Services Consumer Staples
Lastly, oversold and overbought indicators can be used to hone in on investment decisions with added precision. In late 2020, the Technology Select Sector SPDR ETF (XLK) triggered a commonly used overbought signal when its relative strength index (RSI) spiked. The ETF immediately sold off by as much as 12.9% over the following months.
Sector Rotation in Practice
One argument for using a sector rotation strategy is that 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 which 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
Visualize the Economic and Market Cycles
Want to determine the current cycle stages? Fundamental Charts can illustrate market performance along with over 250,000 economic indicators, including interest rates, unemployment—and US GDP, as illustrated in the charts above.
Plotting ratios, spreads, and correlations along with US recession backdrops can also uncover how different securities fare throughout the economic cycle and its stages.
Screen for Investment Ideas
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.
Screening templates are also available to get you started. Find momentum stocks or stocks trading near lows, as well as ones with attractive relative metrics against the market, their respective industry, and respective sector.
• Anfield US Equity Sector Rotation ETF (AESR)
• ATAC US Rotation ETF (RORO)
• Main Sector Rotation ETF (SECT)
• SPDR SSGA Fixed Income Sector Rotation ETF (FISR)
• SPDR SSGA US Sector Rotation ETF (XLSR)
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.
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