Sector rotation is a strategy involving the movement of investment capital from one sector of the economy to another in an attempt to beat the market; strategically overweighting and underweighting certain sectors based on expected performance. Certain sectors of business profit more in certain stages of an economic cycle and many traders/investors attempt to profit through speculating and timing a particular cycle.

Figure 1. Simplified theoretical model used by various economists for decades shows certain sectors are stronger at different points in the economic cycle. Depicted is the relationship between sectors and the points at which their market brethren thrive from the economy. Investors prompt the "Market Cycle" to precede the "Economic Cycle" in anticipation of coming economic conditions.

There are peaks and troughs in economic activities, based on its assessment of such factors as gross domestic product and employment growth. Growth periods vary; some as short as 1 year and others as long as 10 years, with a historical average of approximately five years.

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 - Signs of Recession and Recovery as depicted in figure 1.

Start of Recession – A period where affairs begin to go dire for the economy in general; a) consumer expectations are at their worst, b) industrial production is falling c) interest rates are at their highest and d) the yield curve is flat or even inverted. Historically, the following sectors have faired better during these bumpy periods:

  • Services - nearer the beginning
  • Utilities
  • Cyclicals and transports - nearer the end

Full Recession - A period that is less than stellar for businesses and the unemployed; a) GDP has been retracting, b) quarter-over-quarter, c) interest rates are falling, d) consumer expectations have bottomed and the yield curve is normal. Historically, the following sectors have faired better during full recessions:

  • Cyclicals and transports - nearer the beginning
  • Technology
  • Industrials - near the end

Start of Recovery – A period where things are beginning to pick-up; a) consumer expectations are rising, b) industrial production is growing, c) interest rates have bottomed and the yield curve is beginning to get steeper. Historically, the following sectors have faired better during early recovery:

  • Industrials - nearer the beginning
  • Basic materials industry
  • Energy - nearer the end

Full Recovery - A period that may be characterized by certain occurrences; a) rapidly rising interest rates with a flattening yield curve, b) consumer expectations may be starting to decline, c) industrial production is level. Historically, the following sectors have faired better during full recovery:

  • Energy - nearer the beginning
  • Staples
  • Services - nearer the end

Rule of Thumb - how markets buy and sell:

Other recommended reading: - Cyclicals

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