Sector Rotation
> Sector Rotation Chart
Classic Rotation Chart of Business and Stock Market Cycles
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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