 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.
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:
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:
Finally, past performance isn’t always indicative of future results. -Paul R. Rossi, CFA
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AuthorPaul R. Rossi, CFA 
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August 2022
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