What is Market Rotation, or Sector Rotation strategy?
Have you ever looked at S&P 500 index and compared it with your portfolio, only to be disappointed by the results? This happens mainly because the index contains different sectors, industry groups, and a myriad of stocks.
Each industrial sector responds to macro-economic factors, economic policies and news differently (Lamponi, 2014). The world economy is complex, and at different times, some sectors do better than others due to their unique characteristics.
As the well-worn phrase goes, ‘there’s always a bull market somewhere.’
What is Sector Rotation?
Sector rotation (a.k.a market rotation) is an investment strategy of moving money from one industry sector to another, in an attempt to beat the market.
Originally, it emerged as a theory from the National Bureau of Economic Research (NBER) data (dating as far back as 1854) on economic cycles. This collection (of data) established the start, end and duration of business cycles, the way we know these today.
How does it work?
Sector rotation strategy aims to exploit mini-bull markets.
The principle behind sector rotation investing strategy is simple; the investor looks at the performance of several sectors (usually within an index such as S&P 500) and invests in the top ones.
Based on the performance for each sector, the investor moves those funds across other sectors that are on an uptrend.
It is a fusion of active management and long-term investing.
During a bull run, it is easier to beat the benchmarks since the entire stock market is in upswing; find the strongest sectors, ignoring the worst performing sectors, to implement a market rotation strategy.
In a bear market, however, it becomes arduous to do so, since many sub-sectors are in a decline along with major indexes.
There is an opportunity in the bear market as well; you can always find sub-sectors (also called mini bulls) that are on the rise and improve the average annual return.
A convenient way to invest in sectors is through Sector ETFs or Sector Funds (which are commonly structured as mutual funds or ETFs).
On a tangential note, there are inverse ETFs as well that let you make money when the underlying index or sector is in a downtrend. Inverse ETFs turn the bear into a bull by ‘shorting’ the market.
Investing strategies in a bear market require deeper insight than in a bull market.
During the financial crisis of 2007-8, the following ETFs performed exceptionally well. It also demonstrates how sector rotation can significantly boost your portfolio earnings.
||Short QQQ ProShares
||Short S&P 500 ProShares
||Short Dow30 ProShares
You don’t always have to short in a bear market to earn a profit.
During the same time, the following asset classes also performed really well.
||Barclays 20 Year Bond Fund
||CurrencyShares Japanese Yen Trust
||SPDR Gold Trust
||PowerShares Bullish Dollar Index
The table above is a snippet of investment opportunities available to those who know where to find them.
In fact, by mid of November 2009, sectors such as Brazil had gained +114% and the emerging market index was up +64%, in comparison to S&P 500 which was up merely +21%.
Hence the narrative that there is not one market, rather a range of sub-markets.
If you know your market well enough, you can devise profitable investing strategies. Some of these sub-sectors will always be in an uptrend, beating the general indices.
The question, however, remains, how to find profitable sectors to rotate investments?
To answer that you should be well aware of the four main stages of the market cycles, which are;
||Falling prices, which transition into a long-term low
||Rising prices (usually after "Market Bottom")
||When the bull market flattens
||The phase before "Market Bottom"
Knowing the market stages is only the beginning, this knowledge needs to be coupled with the economic cycle. The economic cycle takes into account more factors and paints a clearer picture, revealing sector rotation opportunities.
Here are the four main stages of the economic cycle:
||This stage is indicated by; falling interest rates, shrinking GDP, low consumer expectations, and the normal yield curve. Sectors that have historically thrived in such circumstances are;
- Cyclicals and transport (at the beginning)
- Industrials (towards the end)
||Factors such as rising consumer expectations, growing industrial production, extremely low-interest rates, and the steepening yield curve are indicative of early recovery. Sectors that have historically performed well during this stage are;
- Industrials (at the beginning)
- Energy (towards the end)
||When the interest rates rise rapidly, along with; a flattening yield curve, declining consumer expectations and a flat industrial production, this is a typical sign of late recovery. Profitable sectors (historically) during this stage are;
- Industrials (at the beginning)
- Services (towards the end)
||When the entire economy starts to go bad it is indicative of an early recession. Consumer expectations are at their lowest while interest rates are at their highest, industrial production is on a rapid decline, the yield curve is either flat, or flattening, or in certain cases, inverted. However, in such tough times the sectors that might be of interest to investors based on their historical performances are;
- Service (at the beginning)
- Cyclicals and Transport (towards the end)
The market, and the economy face ups and downs. The following classic sector rotation chart sums up how the market cycle and economy cycle move in tandem;
Market versus Economy Cycles and Sector Rotation
Historical data suggests it is the market cycle that leads the economic cycle.
For instance, as the economy starts growing, the stock prices also increase, and when an economic slowdown becomes imminent, the stock prices decline as well.
The corresponding movement of the economy and market cycles can take from months to years to occur, however, the historical data confirms the recurrence of these cyclical patterns.
Designing a successful rotational strategy requires a lot of thought, and includes various factors such as interest rates. A study by Phillip C. James (2014) evaluates sector rotation strategy based on changes in interest rates.
The results demonstrated that a sector rotation strategy based on changes in monetary policy - specifically interest rate adjustments - can remarkably improve portfolio returns.
Similarly, momentum investing is another popular sector rotation strategy since it spots the sectors that have been performing well within a certain time frame. It is another form of relative strength investing.
Mebane Faber (2010) wrote a white paper testing the relative strength investing using data for US equity sector dating back to 1920s. He discovered that buying the sectors with the largest gains outperformed buy-and-hold over a test period exceeding 80 years.
(Image taken from Relative Strength Strategies for Investing by Mebane Faber, 2010)
He concluded his research by stating that the strategy could have been further improved by using simple trend following.
Investment rotation is a part of active portfolio management; switching among sectors based on research. Besides profiting from mini bull market rotation efficiently diversifies your portfolio and boosts returns. However, it is more suited to institutional investors or high net-worth individuals due to its nature (of moving capital across sectors).
Faber, M. (2010). Relative strength strategies for investing.
James, P. C. (2014) Sector Rotation and Interest Rate Policy. International Journal of Business and Social Research. 4(5). 124-130.
Lamponi, Daniele. (2014) The Long-Term Performance of Equity Investment Strategies and the Correlation Trap. The Journal of Portfolio Management 40 (4), 135-142.