Sector rotation is a tactical and strategic investment strategy deployed by many investors 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 - overweighting the leading sectors and underweighting the 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, macro-economic, internal, and external forces. It may be challenging 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 need to 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 is pivoting toward a tightening process to fight inflation, one would expect the business cycle may be moving past the mid-cycle recovery/expansion phase and toward a market top or economic peak. The next phase is a 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 today’s market environment previous markets, including the devasting 2007-2009 global financial crisis and the equally brutal 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, subsequently collapsing into the bear market.
As expected, before the 2000-2002 tech/telecom bubble and dot.com blow-up, energy also 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 managed to establish 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.
Another relevant study worth mentioning is the Relative Rotation Graph (RRG) study. In the past eight (8) weeks, the RRG study shows mixed readings. Divergences between key S&P sectors hint at an impending inflection point in the stock market and the economy.
The energy (XLE), utilities (XLU), consumer staples (XLP), healthcare (XLV), financials (XLF), Materials (XLB), and industrials (XLI) remain the sector leaders, evidenced by their positions within the Leading Quadrant. The positioning of Healthcare and Materials suggest these two sectors are well-positioned to outperform peers over the near term.
However, energy has been declining for the past three weeks, suggesting the commodity-based sector is losing relative price momentum. Nonetheless, the relative strength performance remains bullish, signaling the recent pullback is likely a correction within a bull trend.
Financials and consumer staples have weakened as their price momentums have fallen. Based on the current trend, they are likely to fall into the Weakening Quadrant as early as next month, suggesting near-term rotations out of these two sectors.
Consumer discretionary and technology may have bottomed near-to-intermediate-term. However, the sharp rallies are questionable as they may be oversold bounces within primary bear markets. The ability of these two sectors to move from the Lagging Quadrant into the Improving Quadrant can help to solidify their respective bottoms.
In conclusion, the above signals paint a confusing and mixed stock market and business cycle environment. It is not clear the SPX Index has peaked or is it conclusive that a market bottom has developed. Since stocks are leading indicators of business cycles, often peaking and bottoming months, and quarters ahead of the actual economic tops and bottom, investors and traders need to track the rotations within S&P sectors into the second quarter when corporate earnings are released. The continued relative strength in the commodity sectors (i.e., energy and materials) is problematic as this warns that the business cycle may be peaking soon. Historically, energy and materials can still relatively outperform the market into the second or third quarter of 2022, as SPX enters into a consolidation phase or undergoes another sell-off below its recent Jan and Feb 2022 lows. The relative performances between consumer discretionary, communication, and technology sectors versus consumer staples, healthcare, and utilities may hold the key to the next phase. Weak relative strengths from cyclical sectors and strong relative strengths from defensive sectors warn of the next recession.