If you've spent any time at all following financial markets, you've probably heard of sector rotation. Certain sectors of business profit more in certain stages of an economic cycle. This simple arrangement of stages provides a useful road map to traders of most stripes.
What Is Sector Rotation?
Sector rotation is an investment strategy involving the movement of money from one industry sector to another in an attempt to beat the market. It sprouted as a theory from National Bureau of Economic Research (NBER) data on economic cycles dating back to 1854. It's thanks to this cadre of government and academic economists that we know the start, end, and duration of each business cycle.
You may have heard of the NBER before: They're the ones that announce that a recession has officially ended – three years after the fact. The data may be slow to develop, and a bit dry, but a little digging can provide insight that investors can use to make decisions.
It's important to remember that past performance in the stock market does not always mean future success, and a particular sector may or may not be in favor at any time. That said, let's look at the data that can help investors decide what they should be invested in during any given market cycle.
Market Cycle in Four Stages
Markets move up and down just like the economy. For the purpose of this discussion, we will divide this cycle into four stages:
- Market bottom: This is represented by diving prices, culminating in a long-term low.
- Bull market: This begins as the market rallies from the market bottom.
- Market top: Just as it sounds, this stage hits the top as the bull market starts to flatten out.
- Bear market: Here we go down again. This is the precursor to the next market bottom.
Most of the time, financial markets attempt to predict the state of the economy – anywhere from three to six months into the future. That means the market cycle is usually well ahead of the economic cycle. This is crucial to remember because as the economy is in the pits of a recession, the market begins to look ahead to a recovery.
Economic Cycle in Four Stages
Here is a list (in the same order as above) of four basic stages of the economic cycle, and some associated telltale signs. Again, keep in mind that these usually trail the market cycle by a few months.
- Full Recession
This is not a good time for businesses or the unemployed. GDP has been retracting, quarter-over-quarter; interest rates are falling; consumer expectations have bottomed; and the yield curve is normal. Sectors that have historically profited most in this stage include:
- Cyclicals and transports (near the beginning)
- Industrials (near the end)
- Early Recovery
This is when things start to pick up. Consumer expectations are rising; industrial production is growing; interest rates have bottomed; and the yield curve is beginning to get steeper. Historically, successful sectors at this stage include:
- Industrials (near the beginning)
- Basic materials
- Energy (near the end)
- Late Recovery
In this stage, interest rates can be rising rapidly, with a flattening yield curve; consumer expectations are beginning to decline; and industrial production is flat. Historically profitable sectors in this stage include:
- Energy (near the beginning)
- Services (near the end)
- Early Recession
This is where things start to go bad for the overall economy. Consumer expectations are at their worst; industrial production is falling; interest rates are at their highest; and the yield curve is flat or even inverted. Historically, the following sectors have found favor during these rough times:
- Services (near the beginning)
- Cyclicals and transports (near the end)
The Bottom Line
With this general outline in mind, traders can try to anticipate which companies will be successful in the coming stages of an economic cycle. Equally important can be the signs the market is exhibiting regarding future economic conditions. Watching for these telltale signs can give great insight into which stage traders believe the economy is in.