What does Sector Rotation have to do with today’s market?

How are the stock market and the economy related? Logic would tell us that when the economy is doing well, companies tend to do well, and their stock prices tend to rise. When the economy is doing poorly, companies tend to do poorly, and their stock prices tend to fall. Anyone that has been in the markets for any length of time can soon tell you that logic is not always the best guide to investing.

The sector rotation model is a way of investing that takes advantage of the relationship between the stock market and the economy. The model suggests that different sectors of the stock market tend to perform better in different phases of the business cycle. The stock market is a leading indicator of the economy, which means that stock prices tend to rise before the economy starts to grow and fall before the economy starts to contract. Investors who use the sector rotation model can try to improve their returns by shifting their investments into the sectors that are expected to perform best in the current phase of the business cycle. Logic would dictate that during economic expansions, sectors that benefit from economic growth, such as consumer discretionary and technology, would tend to perform well. During economic recessions, sectors that are less sensitive to the economy, such as utilities and consumer staples, tend to perform well. 

The thing about logic however is that it doesn’t always apply to the financial markets. One of Warren Buffett’s most famous quotes is “Be fearful when others are greedy, and greedy when others are fearful.” This quote means that investors should buy stocks when the general public is in a state of fear, and sell stocks when the general public is buying and feeling “bulletproof”. 

In looking at the sector rotation model, many professional fund managers and investors are looking at the current state of stock market leaders (technology, communications, and cyclicals) combined with the fear of “impending recession”. These two clues together combined with much of the momentum we are seeing in the market could make for a strong buying opportunity for educated investors and fund managers.

Here are some tips for using the sector rotation model:

• Do your research. Before you start shifting your investments, it is important to do your research and understand the current phase of the business cycle. You can use economic indicators such as GDP growth, unemployment, and inflation to help you determine the current phase of the business cycle.
• Use a diversified portfolio. Don’t put all of your eggs in one basket. By investing in a diversified portfolio of stocks, you can reduce your risk and improve your chances of achieving your investment goals.
• Be patient. The sector rotation model is not a get-rich-quick scheme. It takes time to identify the sectors that are expected to perform best in the current phase of the business cycle. Be patient and don’t panic if the market takes a downturn.

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