Investors aim to use trading strategies that maximize profits by exploiting market inefficiencies. Today, it is easy to find numerous trading systems and strategies whose authors claim to have found a universal solution with returns higher than those of broad market sectors. The credibility of most of these claims remains questionable. However, there are some strategies among these developments that can actually yield high profits. One such strategy is the sector rotation strategy.
From this article you will learn:
- The sector rotation strategy leverages the cyclical nature of market phases to achieve returns greater than the broad market index by focusing on sectors that outperform in each phase.
- Despite the strategy’s potential for higher returns, it involves increased volatility and subjective assessments of market phase transitions, which can lead to timing issues and higher management costs.
- Numerous real-world examples and investor experiences support the viability of the sector rotation strategy, demonstrating its potential for outperforming broad market indices over time.
Key Principles of the Sector Rotation Strategy
The sector rotation strategy is based on the theory of cyclical market processes. It asserts that the market cycle goes through four phases:
- Early phase. This phase reflects recovery after a recession. It is characterized by a sharp transition in the state of the economy and business activity from negative indicators to rapid growth (e.g., in macroeconomic indicators such as GDP dynamics, business activity, industrial production). This phase is followed by the cessation of strict monetary policy measures, providing an additional stimulus for profit growth. In response, all economic processes accelerate, sales increase, and inventory levels decrease.
- Middle phase. This phase of the business cycle is usually the longest. It is characterized by the continued positive dynamics of processes, though the growth rate somewhat declines. A neutral monetary policy continues to stimulate economic activity, and company profits reach a new stable level. A balance is achieved between sales levels and inventories.
- Late phase. This is the phase of an “overheated” economy. There is a significant slowdown in economic growth rates, and inflationary processes develop. In response, monetary policy tightens, reducing the availability of cheap loans. Expensive credit negatively impacts company profit dynamics. Sales decline, and inventory levels increase. The economy teeters on the brink of recession, held back only by strict restrictive measures.
- Downturn (Recession). This phase is marked by a shift to negative dynamics in economic activity. Corporations show decreased profits, and available credit is insufficient to sustain growth or stabilize processes. Monetary policy shifts from restriction to stimulation. While low sales levels persist, inventories decrease, indicating preparation for the start of a new cycle..
The second postulate of the theory states (and this is confirmed by numerous statistical studies) that different sectors of the economy exhibit different behaviors in each phase of the cycle. Most researchers, aiming for practical application of the data, focus not on abstract sectors but on those delineated within the S&P 500 index.
These sectors are:
- Information Technology (IT)
- Health Care
- Financials
- Communication Services
- Consumer Discretionary
- Industrials
- Consumer Staples
- Utilities
- Real Estate
- Energy
- Materials
Statistical data obtained over a significant historical period have allowed for the generalization of the dynamics of company stocks in each sector during each phase of the cycle.
| Sector | Early | Middle | Late | Downturn |
| IT | P | P | NN | NN |
| Health Care | N | PP | PP | |
| Financials | P | |||
| Communication Services | P | N | ||
| Consumer Discretionary | PP | N | NN | |
| Industrials | PP | NN | ||
| Consumer Staples | PP | PP | ||
| Utilities | NN | N | PP | |
| Real Estate | PP | NN | ||
| Energy | NN | PP | ||
| Materials | P | NN | PP |
The letters in the table mean:
- PP – the sector is significantly above the market.
- P – the sector is above the market.
- N – the sector is below the market.
- NN – the sector is significantly below the market.
- Unfilled – the sector correlates with the market.
By analyzing this, there is a real opportunity to form a portfolio in such a way that, in each phase of the business cycle, it predominantly contains stocks from sectors that are significantly above or above the market. This approach allows for returns greater than those demonstrated by the broad market index.
The strategy involves active investing. When signs of a new business cycle phase appear, the portfolio needs to be restructured.
Advantages of the Sector Rotation Strategy
The main advantages of the cyclical sector rotation strategy include:
- Opportunity for higher returns. The possibility of achieving returns higher than those demonstrated by the broad market.
- Reduction of losses during crises. By including stocks from sectors that are above the market in the portfolio, it is possible, if not to completely neutralize the decline, then to significantly mitigate it. This is also facilitated by the significant weight in the structure of so-called “defensive” sectors, which in any phase remain predominantly neutral or perform better than the market. These include, for example, the consumer staples and financial sectors.
- Simplicity of portfolio formation. For deep diversification, it is sufficient to buy ETFs corresponding to the sectoral indices of the S&P 500 in accordance with the calculated weight coefficients. Restructuring the portfolio is also not problematic – just add additional funds and purchase the necessary ETFs based on the current market phase. The method of selling “excess” and buying securities with the freed-up funds, whose weight needs to be increased, also works.
- No need for constant portfolio monitoring. Investors do not need to constantly monitor the portfolio and market situation. To achieve positive results, it is enough to have basic knowledge of fundamental analysis and conduct it regularly to avoid missing the start of the next cycle phase.
- Works across all time frames and markets. The strategy is effective in any time frame, markets, and countries – the cyclical phase change has been confirmed over a long historical interval that covered both growth periods and the deepest economic crises.
The strategy’s results can be further improved by foregoing the use of funds and independently selecting stocks from various sectors. This way, one can optimally balance the portfolio shares of growth and value stocks and gain additional returns by selecting dividend-paying stocks.
Risk Factors for Sector Rotation
The risks associated with using the strategy include:
- Increased volatility. Local factors specific to each sector can lead to heightened volatility.
- Subjectivity in assessing phase е The subjective evaluation of transitions between business cycle phases can cause delays in portfolio restructuring or premature restructuring. Both scenarios can add “downside volatility.”
- Potential underperformance. Despite overall gains compared to the broad market, a portfolio formed according to the strategy may underperform the market at certain times.
- Complexity in analyzing results. The frequent restructurings make it challenging to analyze the strategy’s performance, identify errors in the trading system, and make necessary corrections.
- Higher costs. Active portfolio management leads to increased costs, including higher absolute commissions for brokers and exchanges or higher fees for fund management companies.
Nonetheless, today there are numerous materials available online where investors share their experiences with sector rotation and demonstrate their results with real examples. A general analysis of such publications indicates the strategy’s viability and its potential for outperforming broad markets.