Last Updated on 3 April, 2021 by Samuelsson
In the stock market, trends come and go. A hot stock today may not be hot in a few months. It is your job, as a trader, to try to identify and move your money from low-performing stocks to those in good momentum. Sounds like a rotation strategy? Let’s find out.
Rotation strategy for stocks is a trading method whereby a trader moves money from stocks that are out of trend to trendy (hot) stocks using a top-down approach. With this approach, you first identify the market sector that is likely favored by the current stage of the economic cycle and then pick the best-performing stocks in that sector.
In this post, you will learn the following:
- What rotation strategy for stocks is all about
- How sector rotation works with stocks
- Why you should consider a sector rotation strategy
- Factors to consider when constructing your portfolio
- The risk factors to consider
- Why rotation strategy for stocks may fail
- The benefits of sector rotation strategy for stocks
- The disadvantages of sector rotation strategy for stocks
What is a rotation strategy for stocks?
In stock trading, rotation refers to the act of moving money from stocks in one sector of the economy to those in another sector. It involves using the proceeds from the sale of stocks in a poorly performing sector to buy stocks in a top-performing sector of the market/economy. The rotation strategy is used as a way to capture returns from market cycles and to diversify holdings over a specified holding period.
In essence, the rotation strategy for stocks is a method of trading whereby a trader moves money from stocks that are out of trend to trendy (hot) stocks using a top-down approach. With the approach, the trader first identifies the market sector that is likely favored by the current stage of the economic cycle and then picks the best-performing stocks in that sector.
So, one thing is clear, it is not a passive investing strategy. Instead, it is an active trading strategy that may be difficult to implement and manage as it involves a lot of risks — the associated costs tend to be fairly high. Moving your investment capital from one economic sector to another will normally incur some trading cost — both in selling the stocks in one sector and in buying stocks in another sector.
Despite the costs, when done rightly, rotation strategy can help investors improve their returns. It enables them to move the money invested in stocks from one industry to another in anticipation of the next stage of the economic cycle so as to benefit from the industries that are favored at each stage. As you would agree, the economy tends to move in reasonably predictable cycles, with various industries (and the companies that dominate the industries) thriving in one stage of the economic cycle while languishing during another stage.
The fact that the stages of the economic cycle can and do affect the performance of stocks in different industries has spawned an investment strategy that is based on sector rotation. In fact, even those who don’t entirely base their stock trading strategy on sector rotation would be wise to anticipate the different stages of the economic cycle and plan their portfolio accordingly.
Understanding the sector rotation strategy
The sector rotation theory is a way of creating stock market trading patterns. A sector, in this context, is understood to mean a group of stocks representing companies in similar lines of business. The theory is that these stocks can be expected to perform similarly, while different groups of stocks which have been categorized according to the aforementioned principle will show differing performance.
Basically, the key elements of the sector rotation theory are as follows:
- Any hot sector (a sector that is currently has done well recently) is expected to continue to outperform others, at least, in the short term.
- These sectors will eventually rotate so that those that were once out of favor will be in favor.
- These movements are connected with the phases of the business (economic) cycle, which is believed to be somewhat predictable.
- With the phase-shift in the performance cycle of sectors, an investor could continually hop from a sector at the peak of performance (and about to start declining) to a sector showing a potential to rise.
How does sector rotation work in stocks?
The theory of sector rotation is based on the analysis of data from the National Bureau of Economic Research (NBER), which demonstrates that economic cycles have been fairly consistent since, at least, 1854. Sector rotation seeks to capitalize on the belief that not all economic sectors perform well at the same time. In other words, the theory implies that a well-performing sector will continue to outperform until it falls out of favor at some point in the business cycle, and then, it will be replaced by another sector in the economy.
In effect, the broad basis of investment theory around sector rotation investing is developed from research on market cycles. Hence, the broad market sector rotation investing seeks to follow market cycles of the economy, and these cycles can be characterized in various ways. However, they are usually categorized as bullish and bearish outlooks, while the terms used to describe the phases of the economy are recessions, recoveries, expansions, and contractions.
The job of an investor using the sector rotation strategies is to use economic market cycles to identify and take advantage of bullish market opportunities that occur during economic expansions while mitigating losses by shifting capital to safe havens during recessionary markets. Most active portfolio managers understand and make use of the concept of sector rotation in managing their investments.
As a retail trader or investor, implementing sector rotation strategies with significant market depth requires comprehensive foresight and a thorough understanding of the concept. To do that, you need to understand two important concepts:
- Business/economic cycle
- Market cycle
Understanding the economic/business cycle
The business cycle, also known as the economic cycle, is the fluctuations of activity in an economy. It explains the expansion and contraction in economic activity that an economy experiences over time, and it can be a critical determinant of equity sector performance over the intermediate term. A typical business cycle features a period of economic growth, followed by a period of slowing growth or the peak, and then a period of contraction or recession, which may be prolonged and deeper — depression. Then comes recovery, which marks the beginning of the next cycle. Note that it’s not all the time that you find the depression phase — in fact, it only occurs once in a while.
As we stated earlier, every business cycle is different in its own way; however, some of the patterns tend to repeat themselves over time. Essentially, the fluctuations in the business cycle are basically distinct changes in the growth rate of economic activity and often involve 3 key cycles — the corporate profit cycle, the credit cycle, and the inventory cycle — in addition to changes in the employment situation and monetary policy.
Of course, unforeseen macroeconomic events or shocks can sometimes disrupt the trend in the economic cycle, but changes in those key indicators have been historically used as a relatively reliable guide to recognizing the different phases of the cycle. For the most part, a typical economic cycle consists of these 4 distinct phases or stages:
- Early-cycle phase: Generally, in this phase, there is a sharp recovery from a recession, which is marked by an inflection from negative to positive growth in economic activity — gross domestic product, industrial production, etc.— and then followed by an accelerating growth rate. The loose credit conditions and favorable monetary policy create a healthy environment for rapid profit margin expansion and profit growth. So, even though business inventories are low, sales growth improves significantly.
- Mid-cycle phase: The mid-cycle phase is typically the longest phase of the business cycle, and it is characterized by a positive but more moderate rate of growth than that experienced during the early-cycle phase. During this time, economic activity gathers momentum, and credit growth becomes strong. Also, profitability is healthy against an accommodative, but increasingly neutral, monetary policy backdrop. Inventories and sales grow steadily and eventually reaches equilibrium relative to each other.
- Late-cycle phase: This phase comes toward the end of economic expansion. It is characterized by an “overheated” economy that is poised to slip into recession as it is hindered by very high rates of inflation. In a bid to control inflation, the regulators implement restrictive monetary policy, tightening credit availability. This leads to a deterioration of corporate profit margins, and economic growth rates slow to “stall speed”. As sales growth declines, inventories tend to build up.
- Recession phase: In this phase, there is a contraction in economic activity — corporate profits decline, and credit is scarce for all economic factors. To help engineer the recovery process, the regulators relax the monetary policy. With more credit facilities, sales gradually pick up, and inventories gradually fall — the next recovery has begun.
Between 1945 and 2009, the US economy has experienced 11 business cycles, with the average length of a cycle lasting a little less than 6 years. During this period, the average expansion is about 58.4 months, while on average, a contraction lasted only 11.1 months. So, if we include the Covid-19-induced recession, then we have had 12 cycles in the Post World War II era.
Understanding the market cycle
Just as the economic cycle is to the general economy, there is also a market cycle for the stock market. Although both cycles are somewhat related, the stock markets don’t move in tandem with the economic cycle. Instead, it moves in anticipation of the economic cycle — at least, it tries to.
The stock market cycle can be divided into four stages:
- Market bottom: This is the period following a bear market. It is characterized by sideways movement at a long-term low point.
- Bull market: This is the period when the market rallies from the market bottom to the top.
- Market top: At this stage, the bull market starts to flatten out. It is characterized by sideways movement.
- Bear market: This is the period the market declines after making a top. What follows this phase is the next market bottom.
Most of the time, the market cycle is usually well ahead of the economic cycle, as the financial markets attempt to predict the state of the economy. The stock market cycle is usually about three to six months ahead of the economic cycle. It is, therefore, important that investors remember this because the market will always start to look ahead to recovery when the economy is in the pits of a recession.
Relating the economic cycle and the market cycle with the rotation strategy
From our discussion so far, it is clear that the performance of economically sensitive assets, such as stocks, tends to be the strongest during the early phase of the business cycle when growth is rising at an accelerating rate. In fact, most of the bull market occurs during the early phase of the economic cycle. By the mid-phase of the economic cycle, the stock market cycle has topped. The late phase and recession phase often coincide with the bear market and market bottom respectively, and then the new market cycle starts when the economy is still in the recession phase.
In contrast, more defensive assets, such as Treasury bonds and safe-haven commodities, typically experience the opposite pattern. These assets have their highest returns relative to stocks during the late-cycle phase and the early part of the recession phase, as investors rush to them to secure their portfolio, while their worst performance occurs during the early-cycle phase when investors are enjoying the bull market in stocks.
With the knowledge of this relationship between the economic cycle and the various markets, some investors seek to profit from fluctuations in the cycle by following the sector rotation strategy. The strategy, as you know, entails “rotating” in and out of sectors — and asset classes — as time progresses and the economy moves through the different phases of the economic cycle.
Rotation strategy calls for increasing your investment in sectors that are expected to prosper during each phase of the business cycle while reducing your investments in sectors or industries that are expected to underperform. The objective is to construct a portfolio that will produce investment returns superior to that of the overall market.
Since 2016, the market consists of 11 sectors — consumer discretionary, consumer staples, energy, financials, health care, industrials, technology, materials, real estate, communication services, and utilities — according to the Global Industry Classification Standard (GICS). Before 2016, real estate was included within the financial sector, but it is now classified as its own unique sector. Some of these sectors perform better in the early-cycle phase, mid-cycle phase, or late-cycle phase. Defensive sectors, such as consumer staples and health care, even tend to do well during the recession phase.
Why consider a sector rotation strategy? Real-world examples
The basic premise of the sector rotation strategy is that stocks of companies within the same industry tend to perform in the same way because the prices of those stocks are often affected by similar fundamental and economic factors. This is based on the sector classification framework, which groups companies on the basis of their business models and operations, such that companies within a sector have similar economic exposure and sensitivities.
Let’s take a look at some real-world examples:
- The dotcom bubble: In the late 1990s and early 2000s, the rapid development of new technologies fueled growth within the tech sector, with most stocks in the sector trended higher.
- The subprime mortgage crisis: During the collapse of the subprime mortgage market and the subsequent credit crisis in 2008–2009, most stocks in the financial sector moved sharply lower The decline of stocks in the financial sector during the financial crisis demonstrated how stocks in the same sector often exhibit similar performance during a particular phase of the business cycle.
So, important economic factors that affect each sector or industry can help you create an estimate of future performance for each sector. Certain sectors may be expected to outperform others, depending on the phase of the business cycle — early, mid, late, or recession. The key thing is to identify sectors or industries that may be well positioned for the current and future phases of the economic cycle.
Although each business cycle is unique, in the past, certain sectors have tended to perform well at different phases of the economic cycle as demonstrated in the table below.
Using rotation strategy for stocks trading: factors to consider when constructing your portfolio
You can use a rotation strategy in your stock trading, but you need to know how to use a sector-based strategy to construct a portfolio. There is a variety of ways to do that, but you have to be careful not to concentrate your capital on a few stocks as that would expose your investment to systemic risks.
Basically, to implement a sector-based rotation strategy, you have to deploy a “top-down” approach. What this means is that you have to first analyze the overall economy and the market — including monetary policy, interest rates, commodity, input prices, and other economic factors. This approach helps you to assess the current economic environment and determine the current phase of the business cycle and use that to select the sectors from where to choose the stocks to trade.
After selecting the sectors — say health care, energies, and consumer staples when the economy is heading into a recession (see the table above) — you will now have to choose the stocks to trade from each of those sectors you selected. To do this, you may have to look at their fundamentals and also do some technical analysis or you may just choose the stocks with rising momentum, as measured by their returns in the last one month. Moreover, you need to sell off most of your positions in sectors that are expected to perform poorly, such as tech, industrials, and real estate, and move the money to the chosen stocks in health care, energies, and consumer staples.
To avoid over-concentrating your investment on a few stocks, it’s better to use a weighting system in your portfolio. That is, you reduce your positions in the sectors that are out of favor and increase your positions in the sectors that are favored, instead of totally offsetting your positions in one sector and moving fully into another sector.
Another way of using the sector rotation strategy is to invest in sector-based exchange-traded funds (ETFs) to gain exposure to entire segments of the market. ETFs enable you to gain the desired sector allocations without having to invest large amounts of capital, and they also allow you to more easily execute a sector rotation strategy and tactically adjust your equity portfolios to increase exposures to sectors you feel have the best return potential.
The risks involved: why rotation strategy for stocks may fail
Of course, sector rotation strategies may help you align your portfolio with your market outlook and the different phases of the business cycle. And, with a good understanding of how certain sectors have typically performed during each phase of the business cycle, you may be able to optimally position your portfolio. If everything goes well and the economy behaves as predicted, the strategy may work.
Nonetheless, a sector rotation strategy exposes your portfolio to higher volatility, and it may end up underperforming the general market. Diversification and using a weighted system may reduce overall risk, but it does not ensure a profit or guarantee against a loss. Some of the industries within each sector may have significantly different fundamentals and may not perform as expected in that phase of the economic cycle.
However, the most important reasons why it is difficult, if not impossible, to consistently make good returns with this strategy over the long term are as follows:
- You have to be right three times to profit from a sector rotation strategy: For the strategy to work, you have to pick the top sectors, then pick the stocks that will rise within those sectors, and then, sell before the sector stumbles. Of course, it’s virtually impossible to consistently succeed at all three over long periods.
- The rotation strategy can push you into the worst-performing sectors: While there are many theories about which sectors will outperform at any given stage of the economic cycle, trying to pick winning sectors — and staying out of other sectors — may not work over the long term. It is possible to end up with heavy holdings in the worst-performing sectors, which would be devastating to your portfolio, even if you confine your investments to well-established companies.
- Implementing the rotation strategy costs money: Anytime you move to a new sector you get charged fees twice — you are charged when you sell your positions in the previous sector and again when you buy in the new sector. While this may not be a big deal if you use discount brokers, the trading fees and commissions can still add up, and these fees will eat into your profits.