To The Moon

Highlights

• Understanding Sector Rotation

• The Four Market Cycles

• The Four Economic Cycles

• Sector Rotation Strategies

• Sector Rotation Risks

What is Sector Rotation:

Sector rotation is the moving of money invested in stocks from one industry to another as investors and traders predict the next stage of the economic cycle.

How Sector Rotation Works:

Sector rotation is the movement of money invested in stocks from an industry or sector to another as investors and traders anticipate the next stage of the economic cycle. The economy moves in predictable cycles of expansion and recession, and investors would be wise to anticipate the cycle to possibly gain higher returns or avoid huge drawdowns. However, it is not easy to spot these changes in real-time, BUT, there are signs we can look out for that can help us take advantage of sector rotation.

The Four Market Cycles:

Highlighted in orange, we can see that the market cycle is lagging behind the economic cycle. This is because the stock market always tries to move in anticipation of the economic cycle. To better understand the market cycle, we can break it down into four phases:

- Market Bottom: The lowest price traded for a stock within a particular referenced time frame. (Investors may take advantage of this phase by accumulating positions in stocks that they find undervalued.)

- Bull Market: A phase where a majority of stock prices are rising or are expected to rise for a sustained period of time - spanning months and even years. (Investors might see their stocks rapidly increasing in value as the bullish sentiment attracts more and more people to buy into the stock market.)

- Market Top: The point at which a stock's price starts to flatten out and trend downwards after a bull market. It is a signal to the incoming bear market. (Investors may opt to secure profits or reduce their exposure during this period to safeguard their portfolio.)

- Bear Market: The complete opposite of a bull market. During this phase, expect to see sharp declines in stock prices - a precursor to the next market bottom. (Investors may opt to take advantage of declining prices or even look out for the market bottom for their next investment opportunity.)

The Four Economic Cycles:

Similarly to the market cycle, the economic cycle can also be broken into four phases.

The U.S. economy tends to be healthy and booming, when the long-term treasury bills prices are higher than the short-term bills prices. However, when the short-term bills prices are higher than the long-term bills, it results in an inverted yield curve* - signifying an oncoming recession.

*To put it simply, a yield curve is a benchmark to measure bonds, interest rates, and the overall health of the US economy.

- Full Recession: A bad phase for businesses and employment rates, leading to negative Gross Domestic Product (GDP) growth over consecutive quarters. Interest rates continue to fall, and consumer expectations hit rock bottom. (The government may provide assistance to their citizens in the form of a stimulus package. This balances the decline, resulting in a normal yield curve.)

- Early Recovery: Things start to pick up during this phase. The economy is stimulated due to the rise of consumer expectations and growth in industrial production. Interest rates have bottomed, and the yield curve starts to get steeper.

- Late Recovery: — Also known as the “late-cycle phase”, during this phase we may observe a rapid rise in interest rates, and a decline in both consumer expectations and industrial growth. The yield curve begins to flatten and it’s generally a sign of an oncoming recession.

- Early Recession: In this phase, the overall economy is in bad shape. Consumer expectations are at an all-time low and industrial production is falling. Sky high interest rates result in businesses halting or reducing growth projects due to expensive loans - leading to loss of employment as companies cut costs. The yield curve is flat, or even inverted.

Taking Advantage of Sector Rotation:

To take advantage of sector rotation, we first have to understand the two main categories of stocks:

• Cyclical Stocks: Companies that make or sell discretionary items and services that are in demand in a thriving economy. They include retailers, restaurants, hotel chains, automobile companies, and more. These stocks tend to be more volatile and follow all the cycles of the economy - from expansion, peak, recession, and recovery.

• Non-Cyclical Stocks: Companies that provide living essentials, such as non-durable household goods, food, healthcare, utilities, and more. These stocks are generally profitable regardless of economic trends and can be relied upon in an economic downturn.

The simplest way to take advantage of sector rotation is by selling your non-cyclical stocks and buying into cyclical ones when you have identified that the economy is expanding. By contrast, if the economy is slow or retracting, you may want to increase your portfolio’s exposure in non-cyclical stocks.

In relation to our current economy in 2022, where inflation is currently occuring, you may benefit by increasing your stake in non-cyclical stocks. A direct result of inflation is the rise in costs and demand for living essentials, thus leading to growth in businesses that provide non-discretionary products and services.

These examples that I have given you show that with a deeper understanding of sector rotation, you may optimise your portfolio to take advantage of the different cycles of the economy. 

Risks of sector rotations:

As with any strategy, taking advantage of sector rotations does come with its own risks.

1. Increased Volatility: Your portfolio may experience increased volatility and even underperform the broader market indexes. This is because industries within each sector may have significantly different fundamental performance drivers that may be covered up by sector-level results, thus leading to significantly different industry-level price performance. In addition, diversification may serve to reduce your portfolio’s overall risk but it does not guarantee profits nor safeguard you from losses.

2. Increased Transaction Costs: The act of buying and selling constantly leads to increase in transaction costs. There may also be a tax consequence, depending on your countries’ tax regulation laws, if you were to make profits.

Conclusion:

By taking advantage of sector rotation, an investor may take an active and relatively easy way of rebalancing their portfolios consistently to potentially capture higher returns and maintain their desired level of risk.

Sector rotation is not suited for all investors. That’s because this type of investment strategy requires you to make more frequent investment decisions than you would with a traditional buy-and-hold approach. It also may increase the overall risk and volatility in your portfolio, and it could introduce transaction costs and taxes you might otherwise avoid.

This of course means that it is not suited for investors who prefer a more traditional, passive approach to investing. Investors may also end up increasing their portfolios overall risk exposure and volatility, and even incur unnecessary transaction costs and taxes that they would otherwise not be exposed to.

Poor execution may also lead to investors not actually achieve higher returns and instead be underperforming the broader market benchmarks. This is why most financial experts recommend investors to stick to passive, index-based investing.

Hope you enjoyed this article. As always, stay safe and may the markets be ever in your favour.

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