By Mark Cussen on January 2, 2022Reading Time: 4 minutes
There are many different strategies that both professional and amateur investors use to generate profits. One of these is by rotating into and out of the various business sectors of the economy. For example from utilities to technology stocks. Many sectors of the world economy rise and fall in a somewhat regular cadence. Those who actively trade their investments can often profit from these patterns over time. The advent of exchange-traded funds has made following this strategy easier and more tax-efficient than ever.
What are business sectors
Which sectors are growing quickly
The world is full of opportunities
In a nutshell, sectors are groups of stocks of similar types of companies, such as technology and utilities. The Standard & Poor’s 500 sectors SPDRs are divided into eleven different categories:
While the SPDRs only invest in U.S. stocks, there are many other ETFs that invest in these same sectors overseas. Some companies could easily be classified in more than one sector. For example, the major cell phone companies could also be placed among consumer discretionary stocks or perhaps technology stocks.
Out of the eleven business sector categories listed above, some of them, such as Consumer Staples, Healthcare and Utilities can be classified as defensive stocks. These are stocks that usually perform well during periods of market contraction. The rest of the sectors listed above are much more cyclical in nature. Their stocks tend to flourish during periods of market expansion and then suffer during recessions and bear markets.
Sector rotation works by moving money from one sector of stocks to another as the economy waxes and wanes. For example, you may concentrate your money in defensive stocks during a recession and then move some or all of your holdings into more cyclical stocks when the markets start to expand again.
Some sectors are more sensitive to economic changes than others. Moving money between these sectors can result in higher profits if you are able to time the markets accurately. Here are three examples of how you can move money from one sector to another, depending upon current economic conditions.
The most obvious example of sector rotation is the opposite of the strategy already mentioned. When the economy begins to slow down, then you could switch some or all of your holdings from cyclical stocks such as technology or industrial stocks into defensive sectors such as utilities or healthcare.
You may also want to hold some defensive stocks during periods of market expansion. These stocks will also profit from economic growth. Defensive companies supply products and services that are necessary for daily living regardless of how the economy performs. As a result, they can be safe havens for your money when a recession hits.
It should also be noted that in most cases, financial advisors will tell you to keep at least a portion of your money invested in all sectors of the economy on a continual basis. This is due to the difficulty of timing markets accurately.
Historical performance has shown that those who buy and hold over time through more than one market cycle have achieved higher returns than those who use technical analysis to move money between various sectors over time.
Those who wish to pursue a sector rotational strategy should instead concentrate a portion of their assets into whichever sectors in the economy are currently performing well. They should also keep a broad base of investments that span all sectors.
If you are invested completely in domestic stocks, then you may want to consider moving some of your into a foreign portfolio investment. While there is some general overall consistency, not all countries rise and fall economically at the exact same time. Investing a portion of your money around the globe in a strategic fashion can allow you to profit from different shifts in economic activity worldwide.
For example, there are many companies outside of the UK and USA which are well worth a look. EU listed countries such as Adidas, BM and LVMH will need no introduction, but others such as ASML and SAP display similar dominance in their related tech sectors as the US big tech without the (somewhat!) exorbitant valuation.
If you use fundamental analysis to determine your holdings, you can approach sector rotation by identifying undervalued stocks. They would be particularly attractive If they have some sort of economic catalyst that could cause them to outperform the overall market in the near future. For example, say there is a breakthrough invention or discovery in a sub-section of the technology sector, and this sector has been under performing the market as a whole.
One area of potential exponential growth is Artificial Intelligence (AI). It is already prevalent in day-to-life so also form part of your stock portfolio. It could also be that a sub-sector has increased in importance, such as semi-conductors.
As with any type of investment strategy, sector rotation does have its drawbacks. Consistently moving your money from one sector to another will generate additional transaction costs, and this can drag down your overall returns over time.
Furthermore, selling holdings in one sector and buying new holdings in another sector will generate a taxable event in many cases. For this reason, sector rotation can be a good strategy to employ inside a tax-advantaged account.
Finally, as mentioned previously, historical performance shows that many (but not all) sector rotation strategies have under performed buy-and-hold strategies over longer periods of time.
Sector rotation is a strategy that allows you to invest more heavily in growing companies and hold less of your assets in under performing companies. But accurately predicting how each sector will perform is an inexact science at best. Nevertheless, many active portfolio managers have embraced this strategy in an effort to outperform the overall markets over time.
Indeed Warren Buffet famously won a bet against those who were trying to do this. In the end a balanced portfolio with exposure to at least 5 sectors, but ideally concentrated around 8 will often outperform.