Analysis of Economics

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Sector Rotation: The Essentials

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. Here, we’ll look at the economic research to back it up and where to find it; the basic sectors of the economy; and the telltale signs of each economic stage.

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 NBER (National Bureau of Economic Research) 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 into investment decisions. Sam Stovall, chief investment strategist at Standard & Poor’s, has done some digging. Here is a recent quote from his indispensable BusinessWeek column, “Sector Watch”:

“The National Bureau of Economic Research sets dates for peaks and troughs in economic activities, based on its assessment of such factors as gross domestic product and employment growth. Since 1945, the U.S. economy has experienced 11 recessions and 10 expansions (it's now in our 11th expansion). Growth periods have lasted an average of nearly five years (59 months, to be exact), with the shortest being 12 months from July, 1980, to July, 1981, and the longest at 120 months from March, 1991, to March, 2001.”

Stovall goes on to suggest that by dividing the NBER cycles into sub-stages, historically successful periods for stocks in certain business sectors become apparent:

“Breaking expansions into early, middle and late phases of equal durations, and recessions into early and late periods of similar lengths, and then analyzing the frequency of the market outperforming the industries in the S&P 500 during these periods, a pattern of sector rotation is apparent….”

He has also written “Sector Investing” (McGraw-Hill, 1996) and “Standard & Poor’s Guide to Sector Investing” (McGraw-Hill, 1995). The guide provides a general idea of how prosperity has historically moved through the economy. 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, due to outlying factors. That said; let’s look at what has worked for stocks in the past. This model is partially borrowed from stockcharts.com.

Market Cycle in Four Stages
Markets move up and down just like the economy. For the purpose of this discussion, we will divide that 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 - 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).
-Technology.
-Industrials (near the end).

Early Recovery -Finally, things are starting 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 industry.
-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. Here are the historically profitable sectors in this stage:
-Energy (near the beginning).
-Staples.
-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).
-Utilities.
-Cyclicals and transports (near the end).

Summary
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 on future economic conditions. Watching for these telltale signs can give great insight into which stage traders believe the economy is in. For those looking to dig deeper into sector rotation, below are three great resources:


Stockchart.com’s interactive SPDR Sector Rotation Chart, is found at:
http://www.stockcharts.com/charts/performance/SPSectors.html

The NBER publishes most of its data online, and is found at:
http://www.nber.org/

Sam Stovall’s weekly column "Sector Watch" on BusinessWeek Online, is found at:
http://www.businessweek.com/investor/list/stovall_toc01.htm

http://www.investopedia.com/articles/trading/05/020305.asp