The Basics of Sector Rotation Strategy

The commentary below is by BigTrends Research, Price Headley's firm. This particular commentary could not be more timely, as it discusses the sector rotation strategy.

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Basics of Sector Rotation

Investors are always looking for the next "big thing" in trading, the best way to get that specific edge, a way to turn a struggling portfolio around or augment a successful trading theory. One such strategy is the Sector Rotation strategy. This trading philosophy is based on sectors and exchange-traded funds (ETFs), which are one of the more popular trading vehicles in today's market. When utilizing the sector rotation strategy, the trader is making a long-term commitment, but also a commitment to be fluid in your management style.

The Basics

Let's start with the strategy. A basic sector rotation strategy contends that the economy runs cyclically - up sometimes, lower other times. This idea was presented by Sam Stovall in his 1996 book, Sector Investing (which is why many call this the Stovall Rotational Strategy). The key is to identify the cycles, buying at the lows and selling at the highs. Success is based on timing, which is why Stovall presented four stages for the economy and for markets.

First, the economic cycle:
1. full-blown recession
2. early recovery
3. late recovery
4. early recession

Next you have the market cycle:
1. market bottom - prices drop
2. bull market - the market rallies
3. market top - the market hits a top and flattens out
4. bear market - prelude to the next market bottom, the market falls

The Model

With an economy that runs in cycles, one needs to understand that there will be sectors that lead and lag the cycles. This need leads to investors trying to anticipate the economic impact of the economic cycle. This anticipation causes the market cycle to proceed the economic cycle.

Confused? Perhaps, but don't fret. The kind folks at StockCharts.com have a widely used sector rotation model, which is included for you below.

The red wave is the market cycle and the green wave is the economic cycle. Across the top of the chart are the sectors into which Stovall divided the economy: technology, basic industry, staples, utilities, cyclicals industrial, energy, services, and finance.

As you can see by the model, certain sectors perform well at different stages of the economic cycle. As an example, cyclicals perform well near the beginning of a recession, tech performs well during the recession, and industrials perform well near the end. Since recession is followed by early recovery, industrials see their solid performance carry over to the beginning of the early recovery portion of the cycle.

What Does This Mean for 2009?

Really, it depends on what portion of the economic cycle you believe we are slogging our way through. If you believe we are in the early recession portion of the cycle, you will want to look at services, utilities, and cyclicals. However, if you believe we are moving through the full recession, keep an eye on the aforementioned cyclicals, technology, and industrials.

As noted in the opening of this piece, a commitment to the sector rotation is a commitment to fluid investing. Remember that the key to this strategy is timing, timing, and timing.

Comments

[BxCapricorn:]

I agree with many of your points and am constantly reminded of people I know who've thought my "investing hobby" is interesting but "just don't have the time to really learn anything like that, and besides, it's all math and numbers..." etc. Now that their 401K's and IRAs have been halved, and my retirement sits in Treasuries (ever since I first read Nouriel Roubini in July 2007), their interest has certainly peaked. When I read his 12 Steps in Feb. 2008, I had already exited my "longs"...

media.rgemonitor.com/p...

and having read The New Paradigm for Financial Markets, by George Soros, I had anticipated this collapse. What truly amazes me is how many people, Soros included (guess who had a significant position in Lehman when it collapsed, by George), ignore a market P/E of over 30 right now, and believe this stimulus plan will spark a lasting rally. I'm equally perplexed at many "inflationists" believe that the money sitting in reserves at banks, will find itself in circulation. With whom? Whom do you know that is still credit worthy? Everything I need to buy, can be found on Craig's List, E-bay, etc. or in a local garage sale for the next five years. I know, I know...you've seen the wheel-barrows-of-money pictures from the Wiemar period. You watch Glenn Beck, and read the articles on goldseek.com. Gerald Caliente, Peter Schiff, and Marc Faber videos are link-forwarded to your mailbox by friends, every day. Yeah, me too. Back in Wiemar, they didn't have freeze-dried food that stores for 25 years. Can goods average a 2 year shelf-life. Four 25-lb bags of rice will set you up nicely. Buy a solar oven if you live where there's sun. Pick up an extra propane tank for your outdoor grill the next time your shopping. If you're worried about spending your life savings on a few month's worth of food, just buy a year's worth now for $3K, on-line, and forget about it. Stop letting the media scare you, and stop letting the financial media rope you back into the market in an attempt to make back what you lost in Autumn. More losses are to come, that's why Kondratieff called this phase of the cycle, the "Winter-Depression".

Feb 15 12:55 PM

[Urbane Gori...:]

Based on Stovall's chart, I'd say we should be investing in Financials, but as has been noted many times, as Financials led us into this mess they may not lead us back out. That's why you hear so many investors say that Tech is where you should be positioning yourself right now.

Hmmmmm .... jegan

Feb 16 05:13 PM