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Sector Rotation Chart - The Classic Economic Cycle for Stock Sectors
Sector Rotation  >  Sector Rotation Chart

Classic Rotation Chart of Business and Stock Market Cycles

Sector Rotation Chart

The classic sector rotation chart is a simple visual to see the business economic cycle and to see how the stock market behaves during each phase of the business cycle.

More importantly, the Sector Rotation Chart also shows us which key sectors of the economy should benefit the most during that time of the economic cycle.  



What is Sector Rotation?

Over the course of a regular business cycle each phase of it has different economic fundamentals which will effect sectors of the economy in different ways.  Some sectors will thrive during a certain economic phase of the business cycle, while others will struggle.  Sector rotation is an investment strategy that takes advantage of these natural cycles by investing in specific sectors of the economy at times when they will perform best in the business cycle.  As the business cycle advances into its next economic phase, capital is rotated out of exising sector holdings into the next group of sectors expected to thrive in the new phase of the business cycle.  Sector rotation is the process of always investing capital is the strongest performing sectors of the economy.

The Stock Market is a Leading Indicator

This basic rotation chart really illustrates 2 separate cycles - the business economic cycle, and the stock market cycle.  The key takeaway point when comparing these two cycles is the fact that the stock market is a leading indicator and leads the business economic cycle by 6 - 12 months on average.  The stock market tries to anticipate each new piece of economic information that is released and respond to it.  You can visually chart certain sectors on an interactive sector rotation chart to see which sectors perform during what stage of an economic cycle.  Another tool to see results is in Smartmoney's Sector Tracker tool.  In strong economic times with economic fundamentals that continue to grow the stock market responds favorably.  When economic data is released that shows a slowing of economic growth, or economic data that does meet the expectations of the stock market it will usually respond in a negative fashion.

The Economic Cycle is Sometimes Hard to Pin Down

We need to observe several key economic datapoints when approaching sector rotation with a fundamental analysis viewpoint to help identify exactly what stage of the economic cycle we are facing.  Sometimes the answer is not so clear and the data may not fit neatly into the segments of the sector rotation chart phases, and this leaves room for interpretation and shades of grey during these phase transition points.  The important takeaway point is to utilize the model to assess what should be happening, and to look at the other datapoints as signs or clues that the economic cycle may be changing.

The Economic Signposts Used to Identify Business Cycle Phases

There are hundreds of economic statistics used by economists and governmental bodies to measure and track economic activity.  For our basic sector rotation chart we will focus on 4 basic economic statistics and observations.

Consumer Expectations

What are consumer expectations doing right now?  How do consumers feel about the economy and their economic livelihood?  In good times consumers have disposable income to spend, feel good about their future economic prospects, and tend to spend money like it will always be there for them.  This has the effect of driving higher GDP in the economy.  Conversely, the opposite also holds true.

Industrial Production

What level is industrial production at in relation to its business cycle?  Is production at full capacity or is it idle?  Businesses behave in a similar fashion to consumers about their business expectations - when times are good and business is expanding with strong profits they tend to spend more on expanding production and facilities.  Conversely, when times are tough businesses pull back on spending, create layoffs, and reduce their expenditures.  This has the effect of lowering GDP in the economy.

Interest Rates

What are interest rates doing right now?  What is the spread between short-term interest rates and long-term interest rates?  What is the trend in interest rate changes?  Rising interest rates generally indicate a growing economy, and lowering interest rates generally indicate a cooling economy.

Yield Curve

What is the slope of the yield curve which charts short term and long term interest rates?  In a healthy economy the yield curve has a positive slope as lenders providing capital for longer periods of time expect a higher interest rate to account for the additional risk and time involved.  Conversely, if the yield curve is inverted where short term rates are higher than long term rates, this generally implies that the bond market is predicting lower future interest rates and a possible recession.

Next up:  How to Use the Sector Rotation Model

 

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