Sector rotation is a tactical and strategic investment strategy deployed by investors to overweight, underweight, and market-cap weight sectors based on economic conditions. It can be a profitable and rewarding experience when executed correctly. It can also be a challenging endeavor if ill-conceived.
Although the concept sounds simple, it is far more complicated to implement. A successful sector rotation strategy depends on different factors, including geopolitical, country-specific, macroeconomic, internal, and external forces. It is hard to know when and where to invest due to conflicting signals from the above.
The sector rotation strategy works best when the economy and the stock market behave rationally. In a difficult market and economic environment, investors must perform detailed analyses to uncover the underlying forces driving the sector rotations.
Momentum-style investing focuses on price, velocity, and the rate of change. Sector rotation studies often incorporate relative strength and relative price momentum analyses to help identify changes in the stock market and business cycles. Understanding the different phases of the economic cycle is not enough. Investors also need to project the leading sectors that will outperform peers.
There are four stages to an economic cycle – the expansion phase (economy is growing), peak or top (economy tops and begins to decline), contraction or recession (economy is declining), and trough (economy bottoms and starts to recover).
Since the Fed continues with its tightening process to contain soaring inflation, this would imply the business cycle has moved beyond the mid-cycle expansion phase and toward a market top and an economic peak. The next economic phase is the contraction or a slowdown of the economy.
Specific sectors are sensitive to changes in economic conditions and can offer subtle clues to confirm the new phase in the economy and the stock market. Near a peak in the stock market cycle, commodities-based sectors often excel as commodity prices rise and the demand for natural resources increases due to the expanding economy.
The relative strengths of the energy and commodity-based sectors often excel under this scenario. As commodity prices soar, it begins to hurt the economy and consumers. Consumer confidence wanes as well as consumer spending. Investors then rotate from energy and commodity-based sectors toward defensive-minded sectors such as consumer staples, healthcare, and utilities.
When the stock market moves past its peak cycle and the economy contracts, early-cycle economically sensitive sectors such as consumer discretionary and technology severely underperform their peers.
While no two cycles are the same, they tend to rhyme. Similarities in past markets can help to identify the current environment. Two specific markets worth reviewing are the devasting 2007-2009 global financial crisis and the equally painful 2000-2002 tech/telecom bubble and dot.com debacle.
Ahead of the 2007-2009 global financial crisis, energy and materials took on a leadership role, outperforming the SPX Index and S&P 500 peers during the summer of 2007. The relative strength outperformance in energy and materials persisted well into the fourth quarter of 2007 while the rest of the markets declined. Eventually, the energy sector would succumb to the broad market selloff. Consumer discretionary and other economically sensitive sectors severely lagged their peers into the market top and contraction.
Also, during the 2000-2002 tech/telecom bubble and dot.com bubble, energy showed similar market tendencies. Energy outperformed the stock market (SPX) and its peers well into the first half of 2001 before encountering strong selling into the second half of the bear market decline. Surprisingly, the materials sector underperformed SPX and the energy sector during 2000 but reached a bottom in late 2000, when other S&P sectors collapsed. The economically sensitive consumer discretionary sector peaked in Mar 2000, alerting investors to the top and a contraction.
The Relative Rotation Graph (RRG) study depicts changes in the relative price momentum and relative strength of the 11 S&P sectors. In the past eight (8) weeks, the RRG study has shown a dramatic shift favoring defensive sectors, reaffirming an economic slowdown and stock market bear decline.
Healthcare, consumer staples, and utilities occupied the top 100-list ranked by SCTR scores with 24, 11, and 10 names each. Half of the top 100 names are defensive.
Energy and materials have declined for weeks with explosive CPI and inflation data. The two commodity-based sectors (energy and materials) have been one of the worst-performing sectors, as evidenced by sharp declines in relative price momentum. Nonetheless, 18 energy names still occupied the top 100-list ranked by SCTR technical scores. Interestingly, 11 consumer discretionary names also remain in the top 100-list.
Does this imply the recent pullback in commodities is a consolidation within an overall commodities structural bull trend?
Commodities tend to be a volatile asset class, noted for their sharp pullbacks. Is the recent consolidation just a normal development within a commodities super cycle?
With 11% of the top 100-list situated within the economically sensitive consumer discretionary sector, it hints that any impending economic contraction may be short-lived and shallow.
Three (3) financial names and four (4) real estate names reside within the top 100-list.
Does this suggest interest rates may be peaking? A flattening to an inverted yield curve tends to precede an economic peak and the start of a recession.
The above suggests a challenging market and economy. However, the analyses also suggest the stock market is forward-looking. Since stocks are leading indicators of business cycles, often peaking 6-9 months ahead of economic tops and bottom, investors and traders need to closely track the rotations within S&P sectors into the second half.
The recent relative weaknesses in the commodity sectors (i.e., energy and materials) may be a consolidation phase. But it can also warn of a slowing economy if the commodities trend continues to deteriorate.
The relative performances between cyclical and defensive sectors can help decide the next economic and stock market trend.
Weak relative strengths from cyclical sectors and strong relative strengths from defensive sectors warn of the next recession. However, if cyclical sectors bottom and outperform peers, they may have already priced in an economic contraction or a recession.