How to Employ a Sector Rotation Trading Strategy

By Michael Griffis, Lita Epstein

In general, the markets are divided into sectors, and at any time some of those sectors are expanding, even during a bear market. Some traders are adept at rotating their investments from one sector to another that is more likely to benefit from the part of the business cycle that’s driving the economy. This basic trading strategy is called sector rotation.

Sam Stovall, chief investment strategist for Standard & Poor’s, wrote the classic on sector rotation, Sector Investing, in 1996. Stovall developed the sector rotation model.

As you can see, he found that market cycles tend to lead business cycles. Markets tend to bottom out just before the rest of the economy is in a full recession. The start of a bull market can be seen just before the rest of the economy starts its climb toward recovery. Markets reach their tops first and enter a bear market before the general economic indicators show a peak.

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Early recovery

You can spot an early recovery when consumer expectations and industrial production are beginning to rise while interest rates are bottoming out. That scenario was evident during the economic cycle discovered during the fall and early winter months of 2003. During the early stages of recovery, Stovall found that industrial, basic industry, and energy sectors tend to take the lead.

We started seeing the early signs of recovery in late 2011 and 2012, as unemployment began to fall, but, full recovery is still a long ways off. The market’s rise to an historic high of 15,400 of the Dow Jones Industrial Index in May 2013 may be the sign that investors finally believe the world is on the road to recovery since the market collapse in 2007/2008.

Full recovery

When the economy has fully recovered, you start seeing signs that consumer expectations are falling and productivity levels and interest rates are flattening out. These factors were seen during the economy’s period of full recovery leading up to the economic peak in December 2007.

During that period, companies in the consumer staples and services sectors exhibited a tendency to take the lead, and interest rates had actually started to fall. As knowledgeable investors know, when that happens, it’s only a matter of time before a recession follows. Investors know that the staples of life are needed even in times of recession, so the stocks of those companies tend to benefit.

Early recession

When the economy reaches the earliest part of a recession, consumer expectations fall more sharply and productivity levels start to drop. Interest rates also begin to drop. Most of the 2.5 million job losses during the 2001 economic downturn occurred during late 2001 and early 2002. During 2001, the Federal Reserve cut interest rates 11 times to try to ease the concerns about the upcoming recession.

The Fed started to raise rates in 2004 but then lowered them again in 2007 during the mortgage crisis. Currently, the Fed’s funds rate was 0 percent. In total, from December 2007 to early 2010, 8.7 million jobs were lost. In February 2013, nonfarm payroll employment was still 3 million jobs lower than at the start of the recession in December 2007.

Utilities and finance sector stocks are the most likely to see rising prices during the first part of a recession, because under those circumstances investors seek stocks that provide some safety and pay higher dividends. Gold and other valuable mineral stocks also look good to investors seeking safety.

It is typical to see banks, insurance companies, and investment firms perform well during the early parts of a recession.

Full recession

Although it may not make much sense intuitively, a full recession is when you first start seeing indications that consumer expectations are improving, which is shown by increased spending. However, industrial productivity remains flat, and businesses won’t increase their production levels until they believe consumers are actually ready to spend again.

Additionally, interest rates continue to drop, because both business and consumer spending are slow, so demand for the money weakens while competition for new credit customers grows between banks and other financial institutions.

During a full recession, cyclical and technology stocks tend to lead the way. They will likely be the companies most beaten down in a full recession, so they will be good candidates to lead in the next recovery. Investors look to safety during a recession, so companies that satisfy that need tend to do best.

Sector rotation

Economic indicators can help you understand the big picture, which, in turn, can help you make better trading decisions.

Of all the economic tools available, sector rotation analysis is probably the most valuable. Even if the sector rotation model can’t help you identify an economic cycle, it can identify sectors and stocks that are ripe for further study.

When you trade, you want the strongest stocks in the strongest sectors, which is why you should monitor sector performance carefully. Knowing the sectors that are performing best enables you to anticipate which sectors are likely to begin outperforming and which are likely to fade. Using those projections, you can start monitoring stocks in those up-and-coming sectors.

For a sector to outperform, the stocks within it must also outperform. You need to be monitoring those stocks before they begin their runs.

Plenty of data is available to help you separate the strongest sectors from the ones that are underperforming. Investor’s Business Daily, for example, ranks nearly 200 industry groups by price performance. You can also monitor sectors by following exchange-traded funds (ETFs), such as the Select Sector SPDRs (Standard and Poor’s Depository Receipts).

You can easily see what is happening in various sectors using StockCharts Performance Charts. At the bottom of the chart, you see a series of predefined performance charts from which to choose. Select S&P sector ETFs to quickly get a visual overview of which sectors are performing well and which sectors are not.

[Credit: Chart courtesy of StockCharts.com]

Credit: Chart courtesy of StockCharts.com