Investing Basics: Understand Stock Market Sector Rotation

Investing in the stock market is easier if you rotate by sector.

Successfully investing in the stock market is a difficult and complex task, but it doesn’t have to be. One way you can simplify the process is to follow a strategy called sector rotation. Sector rotation is the idea that you want to invest in areas of the economy that are expected to outperform based on where we are in the business cycle. This concept is not new, but it’s worth reviewing.

Stock prices are generally driven by a number of factors, ranging from the short-term to the long-term. In the short term, stock prices are largely influenced by company announcements and what’s going on in the news. Over longer periods of time, stock prices tend to follow earnings and growth expectations. For the intermediate term, economic factors such as interest rates, inflation and unemployment commonly dictate the direction of stock prices. The fluctuations of these economic factors comprise the business cycle, and most economists agree that the economy undergoes four phases as it moves forward. Here are the four phases, along with which sectors historically perform the best during each phase:

Growth. This stage of the business cycle is typically characterized by lower unemployment, higher levels of consumer spending, falling interest rates and sharp increases in business sales and profits. As the economy starts to accelerate, investors can take advantage of this growth stage via the consumer discretionary and financials sectors. These sectors generally benefit the most when interest rates fall, gross domestic product rises and borrowing picks up as consumers purchase cars, homes and other big-ticket items. Sectors to avoid include utilities and telecom, as they are traditionally more defensive investments in nature.

Peak. This can be one of the longest phases of the business cycle. It occurs when economic growth rates are strong but are starting to slow down, borrowing (by both consumers and businesses) remains healthy but begins to wane and monetary policy stays accommodative. Economically sensitive sectors still perform well, but a shift usually occurs toward industries that see a peak in demand for their products or services. Businesses become more willing to spend, consumers gain more confidence in the stability of the economy  and the information technology and industrial sectors typically perform the best. Again,the utilities sector lags in comparison to the rest of the sectors because general demand for its services are not dependent on how fast the economy grows.

Contraction. After the economy overheats, it experiences a contraction as banks tighten their lending standards, unemployment rises, corporate earnings begin deteriorating and business inventories tend to build unexpectedly amid decliningsales. However, prior to this point the demand for goods and services was strong, which results in an increase in inflation. When inflation persists, the sectors of the economy in which you want to invest are energy and materials. As you might expect, those two sectors are closely tied to the prices of raw materials such as oil and steel. On the other hand, the consumer discretionary and information technology sectors usually suffer the most as investors shift away from these more economically sensitive areas.

Recovery. During this stage of the business cycle, the economy has bottomed and is in the process of turning the corner. Confidence is at its low point and both businesses and consumers have reined in spending. The good news is that, historically, the recovery phase is usually the shortest one of the group. Of course the most current recovery has been longer than usual, so there are always exceptions. The recovery phase is generally time to become defensively positioned and seek out companies that sell items that we can’t live without, like electricity and toothpaste. These types of companies can be found in the consumer staples and utilities sectors and are more likely to exhibit stable profits and have their stock price hold up better relative to everything else. The sectors that fall out of favor during this phase include industrials and information technology.

The principles behind the sector rotation strategy fall in line with conventional wisdom: You want to invest in the industries that are anticipated to benefit the most based on what stage of the business cycle the economy is in. Unfortunately, no two business cycles are the same, and knowing exactly where we are in the business cycle is easier said than done. However, rotating your investments across sectors and following the aforementioned guidelines can help simplify the daunting task of investing.

Read this article on U.S. News & World Report >