Sector Rotation and Intelligent Investing

At every time period, a certain sector will do well due to changes in the economic and market cycle. Due to these changes, an investor can invest in that sector that is doing well for that time period by buying a sector exchange traded funds (ETFs). Sector rotation investing was the brainchild of Sam Stovall, chief investment strategist at Standard & Poor’s.

Sam Stovall studied NBER (National Bureau of Economic Research) data on economic cycles, dating back to 1854. These data can be found at http://www.nber.org/cycles/cyclesmain.html. NBER is the agency in US that announces when a recession has officially ended – many months or years after it actually ends. How do they do it? By looking at interest rates, employment levels and growth, among others (more info on how they called the recent recession at http://www.nber.org/cycles/dec2008.html). Sam Stovall has this to say, “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….” Hence, the sector rotation model was born.

The economy lags the market by 3 to 6 months as investors try to predict economic events. This was evident during the recent crisis. The market bottomed in March 2009 but the economic numbers began to pick up only much later. This happens because the market attempt to predict the economy well ahead. Remember that the market is made up of people with emotions and feelings.

The market cycle can be divided into 4 stages:

  • Market bottom- This is represented by prices dropping, culminating in a low.
  • Bull market- This begins as the market rallies from the market bottom.
  • Market top- As the name suggests, 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.

The economic cycle can be divided into 4 stages as well. They are:

  • 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 RecessionThis 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).

To look at the yield curve, go to http://stockcharts.com/charts/YieldCurve.html.

To see which sector is currently doing well, one can go to http://stockcharts.com/charts/performance/perf.html?[SECT] and http://www.smartmoney.com/sectortracker/?nav=dropTab. Then, the investor can visit http://finance.yahoo.com/etf/browser/mkt to find out the sector ETFs to purchase.

I decided to backdate this strategy to see if it really works. By going to http://stockcharts.com/charts/performance/perf.html?, I selected the “365 days” option by right-clicking on the scroll bar. From 3rd July 2006 to 1st July 2008, the energy sector was peaking. This corresponds to a market top and full recovery. Currently, the industrials is doing very well, suggesting early recovery. The yield curve is also normal (steep).

Even if one doesn’t want to invest in sector ETFs, an investor can use this model to predict the economic cycle and know when to sell shares when the market is overheated. Once he has liquidated his positions, he can sit and wait patiently to buy undervalued shares during the imminent crisis.  Historically since 1945, there has been a total of 11 recessions and once every 5.5 years (or 66 months) as seen from the NBER website (peak from previous peak). By using the sector rotation model, one can intelligently invest in the markets and liquidate when the needs arises. Even though one cannot predict the market accurately, at least one can use this to intelligently guess where the market is headed next without relying solely on those “economists”. This can become a very good weapon in an investor’s arsenal. (Do take a look at my earlier post on economic cycle.)

(sector rotation model image courtesy of stockcharts.com)

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