Sector rotation is a tactical and strategic investment strategy that investors use to overweight, underweight, and market-cap weight sectors. Sector rotations can be a profitable and rewarding experience when correctly implemented. It can also be a money-losing and challenging endeavor if ill-conceived. Exchange-Traded Funds (ETFs) can be an excellent way to implement sector allocations by overweighting leading sectors and underweighting weak sectors.
Although the concept sounds simple, it is far more complicated than it sounds. Sector performances depend on different factors, including geopolitical, country-specific, macroeconomic, internal, and external forces. It is difficult to know when to move investment capital between sectors or industries due to fluctuations in the above conditions.
The sector rotation strategy works best when the economy and the stock market behave rationally and predictably. Under unusual circumstances, investors must increase the frequency of conducting sector and portfolio reviews. Momentum investing focuses on price, velocity, and the rate of change. Sector rotations need to incorporate relative strength and relative price momentum analyses to identify changes in the stock market and business cycles. Recognizing the next phase can help investors overweight, underweight, and market-weight different sectors.
Since the Fed remains in a tightening monetary cycle to fight inflation, one would expect the business cycle to have moved beyond the mid-cycle recovery/expansion phase and toward a market top or economic peak and then an economic slowdown or contraction phase.
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 materials sectors often climb under this scenario. An inflection in the market is when commodity prices hurt the economy, and consumers lose confidence. Investors will rotate from energy and materials to 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 are vulnerable to severe underperformance against their peers.
While no two cycles are the same, it is valuable for investors to look for clues between the current market environment and previous markets, including the 2007-2009 global financial crisis and the 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, relatively outperforming the SPX Index and many of its S&P 500 peers starting in the summer of 2007. The relative strengths trend persisted well into the fourth quarter of 2007 before the energy sector finally suffered a setback. At the same time, SPX and many sectors peaked and collapsed during the second to the third quarter of 2007. Consumer discretionary and other cyclical sectors consistently lagged their peers into the market top, finally collapsing into the bear market.
As expected, before the 2000-2002 tech/telecom bubble and dot.com blow-up, energy emerged as a leading sector, outperforming the stock market (SPX) and its peers well into the first half of 2001 before succumbing to selling pressure. Surprisingly, the materials sector underperformed SPX and the energy sector during 2000 but established a bottom in late-2000 when other S&P sectors collapsed. The consumer discretionary sector peaked in Mar 2000, alerting investors to an economic contraction as S&P sectors rolled over.
As we fast forward to 2022 and 2023, we have reminded the leaders of the previous bull cycle typically do not come back into leadership roles in a new bull market.
With each new bull market, the emergence of new leaders entices investors to return to the marketplace, which drives the stock market to all-time highs.
If the Fed's tight monetary policies are nearing an end and an economic recovery soon occurs, this can lead to the start of the next bull cycle.
SPX has returned +476% from 3/4/09 to 4/10/23. The leaders of the last bull cycle (2009-2023) are S&P Real Estate (XLRE +1,393%), Technology (XLK +1,214%), Discretionary (XLY +926%), Communication Services (XLC +908%), Industrials (XLI +705.5%), Healthcare (XLV +657%).
The laggards of the last bull cycle are Energy (XLE +235.5%), Utilities (XLU +381%), Staples (XLP +450%), Materials (XLB +481%), and Financials (+646%).
A new bull market leads to the emergence of new leaders. Could the new leaders come from the laggards of the last cycle?
Which of the laggards of the last cycle will emerge to take over market leadership roles?
The three worst-performing sectors are Energy (XLE - 4.75% SPX market-cap weight), Utilities (XLU - 2.96%), and Consumer Staples (XLP - 7.31%). The other two worst-performing S&P sectors, including Materials (XLB - 2.61%) and Financials (XLF – 12.84%), combined with the three poorest-performing sectors, account for 30.5% of the overall S&P market-cap weighting.
A few of the five lagging S&P sectors look promising as candidates to take over market leadership roles in the next bull cycle. See the enclosed charts for further information. However, collectively they are currently too small, at least from a market-cap perspective, to drive the SPX to sustainable record highs.
The traditional way to ignite a new bull cycle is for the emergence of new leadership sectors. However, this may not be the case in the next bull market.
One possible scenario is for a few of the larger leadership sectors from the previous cycle (i.e., Technology, Communication Services, etc.) to return to brief periods of outperformance, enabling investors to gain confidence in investing more aggressively in the lagging sectors once SPX and other broad stock market indexes record all-time highs.
Another scenario is the new bull cycle is no longer a market driven by sector rotations. Could this turn into a stock-picking market, where selective stocks (i.e., value names) emerge over time to lead the broad markets to sustain new record highs?
Time will tell. Within each market, sector, industry group, or security, it is not unusual for technical bases to develop before significant breakouts and the emergence of leaders.
Pay attention to large base formations and relative strength and price momentum breakouts. These collective breakouts will be worth considering as they may lead to the emergence of new leadership sectors, industry groups, and individual securities.