Sector Analysis: How it Works and Why It's Important

What Is Sector Analysis?

Sector analysis is an assessment of the economic and financial condition and prospects of a given sector of the economy. Sector analysis serves to provide an investor with a judgment about how well companies in the sector are expected to perform. Sector analysis is typically employed by investors who specialize in a particular sector, or who use a top-down or sector rotation approach to investing.

In the top-down approach, the most promising sectors are identified first, and then the investor reviews stocks within that sector to determine which ones will ultimately be purchased. A sector rotation strategy may be employed by investing in particular stocks or by employing sector-based exchange-traded funds (ETFs).

Key Takeaways

  • Investors use sector analysis to assess the economic and financial prospects of a sector of the economy.
  • Investors who use sector analysis believe that certain sectors of the economy perform better at different stages of the business cycle and that identifying these sectors can help them find profitable investments.
  • The top-down approach is a type of sector analysis that first focuses on macroeconomic factors that influence an economy, such as unemployment and inflation.
  • Investors who use the sector rotation approach actively shift their investments from one sector to another, depending upon market cycles and trends that impact the potential profitability of various sectors.

How Sector Analysis Works

Sector analysis is based on the premise that certain sectors perform better during different stages of the business cycle. The business cycle refers to the up and down changes in economic activity that occur in an economy over time. The business cycle consists of expansions, which are periods of economic growth, and contractions, which are periods of economic decline.

Early in the business cycle during the expansion phase, for example, interest rates are low and growth is beginning to pick up. During this stage, investors or analysts who do a sector analysis would focus their research on companies that benefit from low interest rates and increased borrowing. These companies often perform well during periods of economic growth. These include companies in the financial and consumer discretionary sectors.

Late in an economic cycle, the economy contracts and growth slows. Investors and analysts will turn their attention to researching defensive sectors, such as utilities and telecommunication services. These sectors often outperform during economic downturns.

Types of Sector Analysis

Two common approaches to sector analysis are the top-down and sector rotation approaches.

Top-Down Approach

Investors who employ a top-down approach to sector analysis focus first on macroeconomic conditions in their search for companies that have the potential to outperform. They start by looking at those macroeconomic factors that have the biggest impact on the largest part of the population and the economy, such as unemployment rates, economic outputs, and inflation.

They then drill down to find those sectors that perform best during the prevailing economic conditions. Lastly, they analyze the fundamentals of companies within those sectors to identify stocks that offer the best potential for future profits.

Sector Rotation Approach

Investors and portfolio managers use a sector rotation approach to rotate their investments in and out of various sectors of the economy. They buy and sell depending on market cycles and trends that influence the profitability of some sectors over others.

These market cycles might be seasonal, such as investing in the retail sector before the end-of-the-year holiday rush to take advantage of stocks that benefit from increased consumer sales. The investor might rotate in and out of cyclical stocks and defensive stocks depending on where in the business cycle the economy is headed.

Sector Taxonomy

In sector rotation strategies, investors may define sectors in a variety of ways. But a commonly used taxonomy is the Global Industry Classification Standard (GICS) developed by Morgan Stanley Capital International (MSCI) and Standard & Poor's.

GICS consists of 11 sectors, which are broken down into 24 industry groups, 68 industries, and 157 sub-industries. The consumer staples sector, for example, consists of three industry groups: 1) food and staples retailing, 2) food, beverage, and tobacco, and 3) household and personal products.

These industry groups are broken down further into industries. Food, beverage, and tobacco, for example, consists of those three, which are then broken into sub-industries. The beverage industry, for example, is made up of three sub-industries: brewers, distillers and vintners, and soft drinks. Sector rotators don't necessarily limit themselves to sectors. They may choose to emphasize industry groups, industries, or sub-industries.