Understanding Sector Rotation and How to Identify Market and Economic Cycles

​As the economy expands and contracts, so do the financial performances of companies across the 11 stock sectors. The 11 sectors are listed below along with some of the industries within each individual sector.

1. Industrial: Aerospace, Airlines, Business Conglomerates, Metal Fabrication, Railroads, Trucking, Waste Management.
2. Basic Materials: Agricultural, Chemicals, Lumber, Steel, Paper, Commodities.
3. Energy: Oil & Gas, Thermal Coal, Uranium.
4. Utilities: Power Producers, Electric, Gas, Water, Renewable.
5. Communication Services: Advertising, Broadcasting, Internet Content & Information, Entertainment, Gaming, Telecom Services.
6. Consumer Cyclical: Manufacturing & Retail Apparel, Auto, Department Stores, Home Improvement Retail, Resorts & Casinos, Lodging, Gambling, Leisure.
7. Consumer Defensive: Beverages, Discount Stores, Education & Training, Farm Products, Grocery Stores, Household & Personal Goods, Packaged Foods, Tobacco.
8. Financial Services: Banks, Captial Markets, Asset Management, Insurance, Mortgage.
9. Health Care: Biotechnology, Drug Manufacturers, Medical Care Facilities, Medical Device, Pharmaceutical.
10. Real Estate: REIT (Healthcare, Hotel, Industrial, Mortgage, Office, Residential, Retail).
11. Technology: Communication Equipment, Computer Hardware, Software, Information Technology Components, Technical Instruments, Semiconductors, Solar.​

When the outlook is positive, economically sensitive companies tend to perform better (at least historically), prompting investors to buy their shares. If the outlook turns bearish, investors might swap out of these types of companies and into companies that can better weather economic downturns. The practice of doing this is known as sector rotation.

Cycles that can trigger sector rotations
The economy goes through cycles, and sector rotations occur at each stage. The 3 most common cycles that investors follow are:

• Changes in the Market Cycle
• Changes in the Economic Cycle
• Oversold vs Overbought Cycles

​The Market Cycle (see below) typically moves ahead of the Economic Cycle, since investors make decisions in anticipation of the future. As such, the current market cycle stage can indicate which sectors will soon become market leaders:

Market Cycle: Market Bottom

What Happens: Systematic risk resulting from a poor economic backdrop brings the whole market lower. Investors prepare to rotate into more economically sensitive sectors.

Best Performing Sectors
Communication Services
Consumer Staples
Health Care
Technology
Utilities

Market Cycle: Bull Market

What Happens: The market bottom has passed, and the worst is over. As economic activity picks back up, so do share prices of cyclical stocks.

Best Performing Sectors
Consumer Discretionary
Energy
Industrials
Materials
Real Estate
Technology

Market Cycle: Market Top

What Happens: Economic growth overheats, and interest rates rise. Investors prepare to rotate into more "defensive" sectors that are less economically sensitive.
​
Best Performing Sectors
Communication Services
​Financials
Materials

Market Cycle: Bear Market

What Happens: Markets begin to drift from highs, and economic activity slows. As investors rotate out of cyclical sectors into defensive ones, selling activity accelerates the market decline.

Best Performing Sectors
Consumer Staples
Health Care
Utilities

​Market Cycles tend to lead Economic Cycles which is what happened both in the 2008 and 2020 recessions.

In 2008, the S&P 500 peaked months ahead of US Monthly Real GDP's top. Stocks sold off in anticipation of a worsening economy.

When COVID-19 became a pandemic in early 2020, the stock market was ahead of the 8-ball once again. Such is nature of both stock prices that discount future cash flows, and investors who want to be one step ahead. 

In both the Global Financial Crisis and the recent Covid-19 recession, the market rebounded well ahead of the fundamentals, which corresponds to the earlier statement, that Market Cycles lead Economic Cycles. 

Layered underneath the Market Cycle is the Economic Cycle. Because economic data is released less frequently, and investors price in their estimates beforehand, the Economic Cycle lags behind market movements. That said, it can provide solid confirmation of prevailing market trends. Sectors tend to perform differently based on the current Economic Cycle (see below) stage:
​

Economic Cycle: Early Expansion

What Happens: Rebounding GDP, Increased Production, Optimistic Consumer Sentiment, Reflationary environment, Low but Stable Interest Rates, Steepening Yield Curve

Best Performing Sectors
Communication Services
Consumer Discretionary Industrials
Materials
Real Estate
Technology

Economic Cycle: Late Expansion

What Happens: Tapering GDP, Tapering Production, Strong Consumer Sentiment, Growing Inflation, Spiking Interest Rates, Flattening Yield Curve

Best Performing Sectors
Consumer Discretionary Energy
Financials
Materials

Economic Cycle: Early Recession

What Happens: Declining GDP, Declining Production, Weakening Consumer Sentiment, High Inflation, Tapering Interest Rates, Flat or Inverted Yield Curve

Best Performing Sectors
Communication Services Consumer Staples
Health Care
Utilities

Economic Cycle: Full Recession

What Happens: Falling GDP, Falling Production, Pessimistic Consumer Sentiment, Deflationary environment, Falling Interest Rates, Normal Yield Curve

Best Performing Sectors
Consumer Staples
Health Care
Utilities

​
Lastly, oversold and overbought indicators can be used to hone in on investment decisions with sometimes added precision.

A very recent example: In late 2020, the Technology Sector triggered a commonly used overbought signal when its relative strength index (RSI) spiked. The sector immediately sold off by as much as 12.9% over the following months.
 
Sector Rotation in Practice
One argument for using a sector rotation strategy is that share prices of companies within each sector tend to move in the same direction. This is a natural effect of sector classification, companies with similar business models are grouped together as they can be economically affected by many of the same factors. At a minimum, investors can gain baseline exposure to a given sector’s sensitivities using individual stocks. Or, broader exposure can be secured using sector ETFs.

An example is the relationship of crude oil prices with major airliners American Airlines, Delta Airlines, Southwest Airlines, and United Airlines, as well as United Parcel Service and FedEx. Despite operating in different industries, these industrial sector companies all benefit from lower oil prices, causing share prices to move higher when fuel costs decline.

Investors can also use a top down approach and look to macroeconomic indicators to assess the current economic cycle stage. Once favorable sectors are identified, rotations are made out of unfavorable ones and into those that are poised to grow.
 
Other Factors to Consider

Some Important Warnings:

• Sector rotation involves active management, which requires frequent monitoring of market and economic events in order to capture opportunities. As explained earlier, the economic cycle takes longer to catch up to the market cycle—and markets could also fail to digest economic news efficiently.
• Mistiming the market cycle can be dangerous to your portfolio.
• Rotating out of a given sector involves selling shares, and each profitable sale triggers a knock on the door from Uncle Sam to collect capital gains tax.
• Taxable events can diminish overall returns, which is why the level of active portfolio management should be considered in order to avoid unnecessary capital gains tax.
• Industries aren’t as homogenous as broader sectors, and a deviation can throw off a rotation strategy. Using the previous example, low oil prices are a major tailwind for major airlines, but other industrials like railroads might suffer as crude oil shipments decline. It might be thought that a rising tide lifts all boats, but there could be outlying industries which fail to swim, reinforcing the need for thorough investment research such as a full top down approach.

Finally, past performance isn’t always indicative of future results. 

-Paul R. Rossi, CFA