A sector rotation can be a good way for investors to find clues to where the market is headed -- but it's a signpost that often goes unnoticed.
Sector rotations happen when big money moves from one area of the stock market to another. Institutional investors may shift millions of dollars from growth stocks in the technology sector to the value stocks of well-established industrial titans that pay strong dividends. It might show up when investors start favoring large-cap stocks in the Dow Jones Industrial Average over small-caps in the Russell 2000.
Investors essentially take refuge in another sector while the industry where they've been investing undergoes a shakeout. This is when it's important to keep an eye on what the stocks in your own portfolio are doing and be ready to consider moving your money.
If the stocks you own in a particular area are suddenly falling below key moving averages -- technical indicators that represent the average price of a stock over a period -- listen to that feedback. It might not be too late to rotate out of those positions and into the new favored sectors. Remember, it might be some time before things return to normal.
Rotations' roots
Sector rotations happen for all sorts of reasons. Among them: changing economic conditions, fresh innovations that ignite consumer interest, or shifts in government policy. Larger themes such as the price of commodities or interest rates can also come into play and drive the fortunes of mining companies or rate-sensitive financial-services firms.
Early signs of a sector rotation often appear when one of the 11 sectors of the S&P 500 begins to take off. Instead of tech stocks rising broadly, you might see chip-maker stocks start to heat up, or perhaps gold stocks may outperform while the broader commodities sector treads water.
One example of a sector rotation occurred when the U.S. emerged from the Covid crisis in 2022. Major stock indexes tumbled after surging in 2020 and 2021. The S&P 500 lost nearly 20%, and the Nasdaq composite plunged dropped about 33%.
The casual investor might have blamed the pullback on the Federal Reserve's aggressive rate increases to combat inflation. But behind the scenes, institutional investors were also rotating out of technology and semiconductor stocks -- sectors that had thrived in 2020 and 2021 -- and into areas that had lagged behind, including energy and oil-and-gas services.
In the first 10 months of 2022, for example, shares of Facebook parent Meta Platforms dropped from around $350 to below $90 while Occidental jumped from roughly $30 to above $60.
Other warning signals may show up anywhere. With Occidental and Meta, not only were their price moves pronounced, but trading volume also was high. In March of that year, volume nearly tripled for both stocks -- a telltale sign of institutional activity. One rule for many individual investors is to follow where the big money is going, and to ride along with them.
Spotting rotations
Another place to look is exchange-traded funds that focus on a certain industry. In 2021, for example, State Street Technology Select Sector SPDR fund climbed 34.7%, then fell 27% the following year. Meanwhile, State Street Energy Select Sector SPDR fund was flat for most of 2021, but jumped 64% in 2022.
Also, investors should pay attention to sectors moving into the top realm -- say, the top five or six industry groups. You'll want to home in on your stocks' respective industry groups and how they rank compared with others in terms of performance.
And if a bull market is continuing to run but your growth stocks are lagging behind, the market may be signaling a shift.
There are a couple of caveats. Many industry groups are price-weighted, so it is possible to have a high-price stock determining the success or failure of a whole group. In those cases, it wouldn't be considered a sector rotation.
Also, choppy markets that are swinging wildly may bring the illusion of sector rotations, but those often don't result in meaningful trends. Sometimes industries fall in and out of favor within a day or two as investors seek refuge. It's best to park your holdings in a safe investment until the smoke clears.
But the key to capitalizing on sector rotation is to keep your eyes peeled for where the big money is flowing. Let the market tell you when and where to pivot.
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