What Traders Should Know about Watching Sector Rotation - dummies

What Traders Should Know about Watching Sector Rotation

By Michael Griffis, Lita Epstein

Traders often try to anticipate changes in the economy by watching specific sectors that they know have tendencies to rise or fall in specific patterns that coincide with one economic or market cycle. Monitoring leading and lagging economic sectors provides insight into the current state of the stock market because some industries perform well at the beginning of an economic expansion and others perform relatively well as the economy cools.

These patterned tendencies are called sector rotation. Although you won’t see picture-perfect sector rotation with every cycle, you will see enough similarities from cycle to cycle to enable you to gain additional insight into the current phase of the economy and the stock market.

You can take advantage of sector rotation in your trading by using sector ETFs.

How to anticipate a new bull market

Economic conditions that foster a new bull market include low interest rates and hints that industrial production is beginning to rise. Traders who monitor these economic conditions often respond to them by buying the stocks of cyclical and technology-based companies. Bullish transition phases usually begin in this manner.

The stocks of companies whose business is sensitive to the economic cycle have traditionally been called cyclical stocks. Within the past few decades, technology-based companies have joined these so-called cyclical companies as bellwether economic indicators. The stocks of cyclical and technology-based companies, and the companies themselves, perform best when interest rates are low. Increased sales of their products drive industrial production numbers higher.

These companies usually lead the market and often rally before an economic trough, or recession, completely bottoms out. Unfortunately, traders jump the gun as often as they get it right, so whenever you see cyclical and tech stocks begin to rally, it pays to be skeptical.

Rather than jump to the conclusion that a sector rally means a bull market is just around the corner, you need to instead consider that it potentially indicates only a bullish transition.

Industries known for making up cyclical sectors include

  • Automobile and automotive component manufacturers

  • Consumer durable manufacturers that produce products such as appliances and consumer electronics

  • Retailers, such as department stores, big-box discounters, and specialty retailers (excluding food, beverage, pharmaceutical, and other nondurable retailers)

  • Media companies, such as movie studios, radio and television companies, and book publishers

  • Hotels, restaurants, and entertainment and other leisure companies

Technology-sector industries include

  • Semiconductor (computer chip) manufacturers and manufacturers of equipment to produce semiconductors

  • Computer and computer peripheral device manufacturers

  • Software and service companies

  • Telecommunication and Internet service companies

  • Information technology service companies

Watch the economy rebound

Strength in the industrial sectors is a condition that usually indicates the markets may be entering a bull market phase. As the economy begins showing signs of growth, you often see a rally in industrial sectors.

Large industrial companies often need to borrow money to increase production, a factor that makes them sensitive to interest-rate changes. These companies tend to perform best in a low-interest-rate environment. Rising industrial production that drives industrial-sector earnings and stock prices higher is no coincidence.

Companies in the industrial sectors include

  • Building products manufacturers

  • Construction and engineering firms

  • Aerospace and defense companies

  • Electrical equipment manufacturers

  • Airlines and air freight, transportation, and infrastructure companies

  • Major manufacturing conglomerates (which are widely diversified companies such as GE, United Technologies, and Tyco)

How to approach a market top

When the economy is firing on all cylinders, industrial production is robust, and interest rates are beginning to rise. However, the stock market tries to anticipate what happens next, and it’s probably nearing its peak. Basic material stocks, energy stocks, and consumer-staples company stocks usually do well under these conditions. When you begin seeing strength in the consumer-staples sector, you need to search for confirmation of a bearish transitional phase.

Companies in the basic industry and materials sectors include

  • Metals and mining companies

  • Chemical companies

  • Construction material companies

  • Forest-product companies, including paper, packaging, and container companies

The energy sectors include

  • Oil and natural gas exploration and drilling services

  • Coal and coal processing

  • Refineries

Companies in the consumer-staples sectors include

  • Food and beverage companies

  • Household product companies and personal-care product companies

  • Tobacco companies

  • Retailers, specifically food, beverage, drug, and other nondurable goods retailers

How to weather a bear market

Healthcare and other service-sector stocks often perform better than the average stock as the economy peaks and as bullish market tendencies fade to bearish outlooks. The stocks of utility and financial companies also tend to perform better than average during bear markets, because they’re considered safe havens from the accompanying tide of falling interest rates and flattening industrial production.

As these stocks begin showing higher relative strength, you need to move your indicator from bearish transition to a bear market phase.

Consumer-service sectors include

  • Healthcare equipment and supplies companies

  • Healthcare providers

  • Pharmaceutical and biotechnology companies

The utility sector includes

  • Electric power generation and distribution companies

  • Natural gas distribution companies

  • Water utilities companies

Companies in the financial sectors include

  • Diversified financial-service companies, including banks and brokerage firms

  • Commercial banks

  • Insurance companies

Taking a relatively long point of view as you monitor the markets for sector rotation is a good idea. This means you’re not interested in the day-by-day ups and downs, but rather you’re trying to evaluate sector performance during periods of many weeks and even months.

Remembering that bull markets tend to lift prices for all stocks is also important. So when you monitor sector performance, you try to find the sectors that are performing better than others. In bear markets, stocks that hold their values, for example, outperform all stocks that have falling prices.