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Sector Rotation Strategy - A Guide for the DIY Investor
Sector Rotation  >  Sector Rotation Strategy

A Sector Rotation Strategy for the DIY Investor

A DIY Sector Rotation Strategy

Here we put all the pieces of a sector rotation strategy together in an easy to follow step-by-step guide so any DIY investor can read the economic and fundamental clues ocurring in the business cycle and position their own investment portfolio to benefit from sector rotation. Regardless of your investment knowledge or experience, after a little reading and research you should be able to follow and implement this basic strategy.  

All you need to do is be able to read the clues of what the economy is doing and where it is expected to go.  Follow these simple datapoints that can be found in the daily business section of any newspaper to get your strategy started today.

DIY Sector ETF Investing

Why pay high fees, subject yourself to below average returns, and get boxed in with minimum investment purchase amounts?  We are convinced that almost anyone can generate better returns than most of the professionally managed sector rotation funds with a little research and a few hours per month.  Our preferred investment vehicle is Sector ETFs, and with a little homework and research you could implement a DIY sector rotation strategy.

Resources You Will Need

Like any DIY project you will need to gather the necessary resources to propery implement a sector rotation strategy based on fundamental analysis of economic and business data.  Here is a list of what you will need:

  • Computer and Internet connection
  • Business section of a major city newspaper
  • A brokerage account
  • Stock Charting Program

Step 1 - Assess 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.  Reading a business newspaper like the Wall Street Journal will give you a pretty clear picture of consumer expectations.

Step 2 - Assess Industrial Production Levels

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.  Reading a business newspaper like the Wall Street Journal will give you a pretty clear picture of industrial production levels and their outlook.

Step 3 - Assess Interest Rate Trends

 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.  The Wall Street Journal usually has a detailed section on interest rates and will often chart the history of interest rates so you can see what trend is developing.  

Step 4 - Examine the 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.  The Wall Street Journal or any other newspaper will usually have a graph of the current yield curve.  

Step 5 - Determine the Current Stage of Business Cycle

Based on your observations in steps 1 - 4, use the Sector Rotation Model to determine which sectors are most likely to benefit in current business cycle environment.

Step 6 - Place your Sector Trades

Position your portfolio with some weighting to the sectors you have determined will benefit the most from the next stage of the economic cycle. Bear in mind that shifts between cycle phases can often be long and drawn out, with no clear distinguishing line to determine when one phase ends and another begins.  Chances are your investment timing may be early, sometimes by many months, or it could be late.  It will all depend upon your ability to read the economic cycle clues, and the actual cycle transitions themselves.  Some are long and drawn out, while others are so quick you can miss them.

Step 7 - Monitor Economic Signals and Repeat Steps 1 - 6 When Necessary

Successful sector rotation takes vigilance and constant monitoring of economic trends and statistics.  As these business statistics change, they may be signaling that another cycle change is under way.  You will need to read the business newspapers daily or weekly to stay on top of economic trends, as your sector investments are leading indicators and will be interpreting and responding daily to the unfolding economic news.

The Pitfalls and Downside of DIY Sector Rotation Based on Fundamental Analysis

Pitfalls of Sector Rotation Based on Fundamental AnalysisIf this is so easy why isn't everyone doing it?  Well in theory it sounds simple enough, but like most things in life once you try to implement them in real-world situtations everything becomes much less clear.  Real life will create situations that the model does not handle well, or it will take a lot longer to play out than anticipated.  What if you are 12 months too early into the next rotation trade?  Or what if you miss the trade by 5 months? Here are some of the pitfalls of using fundamental analysis as the basis for a sector rotation strategy:

Problem Determining Stage of Business Cycle

Its often not clear what stage of the economic cycle we are in, and the transition from each phase of the cycle can take many months to unfold.  Do you invest early, or wait for confimation of sector movement before entering the trade?

Economic Signals Do Not Match Model

Sometimes the economic statistics and signals are false starts, or the results do not match the theory of the sector rotation model.  Not everything will line up in neat and tidy rows to allow you to clearly determing a shift in the business cycle.  Its a running joke in economic circles that most economists cannot even agree on the interpretation of much of the published economic data.

Trading Sectors Too Early

There is a risk that you enter a sector trade much to early and expose your capital to losses, or your capital sits idle for many months or even years while you wait for the sector trade to respond to the next phase of the economic business cycle.

Trading Sectors Too Late

There is a risk that you miss the sector trade as the business cycle has shifted a lot faster than anticipated, and the sector indexes have already fully priced in the next cycle into their valuations.  

It Takes a Lot of Time and Energy

Fundamental analysis of business and economic cycles takes constant monitoring and a lot of your time.  If you miss following the economic data you may miss the signs of the next cycle shift underway.  If only there was an easier way that did not involve so much time and energy...

Luckily We've Fixed the Problems with Fundamental Sector Rotation Analysis!

Sector Rotation is Easier with Technical AnalysisLuckily we have discovered a simply way to time the rotation underlying the economic cycle using leading indicators that anticipate the cycle rotation before it actually occurs.  

With this method you don't focus on lagging economic data, but on what the leading indicator sectors are telling us.  By concentrating on these leading indicators we narrow the focus of timing like a laser beam and never miss the next sectors starting to breaking out...



Up next:  Discover the Next Generation of Sector Rotation Investing 

 

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