You might have heard of sector rotation, or sector rotation theory – it is often taught in economics and finance courses. It generally looks at what economic segments of the market are preforming better than others right now, and what that could mean.
However, it is more than a trite academic exercise, and does not have to be done with miles long complicated spreadsheets. For a stock speculator, it will of course only marginally help you to find great stocks, but it will help you to understand where in the stock market cycle you are.
The common idea behind sector theory is that investors will be trying to anticipate the next stage of the economic cycle (economic recession, early recovery, late recovery, back to recession). Their forward-looking decisions will affect the performance of certain stocks in a cyclical fashion that precedes the economic cycle, called the stock market cycle.
We may look at what stocks and their respective sector & industry are relatively outperforming to get an indication of where we are in the stock market cycle.
The term “investors” again is a misnomer – as always, we’re talking about institutional money, whose large capital firepower makes or breaks market trends. Most fund managers (excluding most hedge funds) have a policy mandate to stay invested in/ exposed to the market with 90%, 95% or even sometimes 100% of their capital at all times.
That means once markets start behaving bad, a lot of money has to move out of risk-on equities and will have to flow somewhere – some goes into the mid-/long-maturity end of the money market, but a large portion of it will still flow into the risk-off market segments.
Risk-off segments are those stocks that have low expected volatility and don’t move a whole lot – neither up, but also not down too much.
Since many funds use earnings-based valuation models, stocks with high stability of earnings during economic downturns (think toilet paper, food, medicine, etc.) will attract a lot of capital.
Some of them as well pay dividends, another reason for money to flow.
This behavior will lead to observable “rotation” of money into certain industries and sectors – it won’t make these stocks high-alfa elite leading stocks, but they will perform relatively better as a group over a certain and usually limited window of time. Often, specific ETFs that comprise stocks from a given sector (e.g. the SPDR sector ETFs shown in the graphic below) will show a relative jump in performance during such times, although not always due to their weight-based calculation that may overrepresent a few stocks over the wider group.
The risk-off sectors commonly outperform late in a cycle, while the risk-on sectors commonly show a lot of leading stocks early in a cycle. However, as the term cycle suggests, some groups show up multiple times:
Risk-off segments outperforming later in cycle
The risk-off segment of sectors and industries often shows relative performance jumps later in a cycle, and stocks are of a ‘cyclical’ nature. Specifically, the industries listed at the bottom of the list are what’s referred to as “defensives” – with which funds (try to) defend their capital with.
- Financials
- Banks (Large national and small regional), Insurances, mortgage-/loans, REITs
- Industrials
- Transports of all sorts of consumer- and capital goods, industrials and materials
- Capital goods & equipment: Used to make finished products/services, but not incorporated into them. Machinery, tools, buildings, vehicles, processing equipment; e.g. engines, agricultural machines, construction & building equipment, hairdryers, printers, services such as waste or pest control, etc.
- Intermediate goods: Components made from raw materials and parts of final products; e.g. textiles, insulation products, wires, cables, water/gas pipes, lighting, building materials, glass, etc.
- Commodities & Basic Materials: Collection/ refining/ extraction/ production/ handling/ sales of natural or agricultural resources, including:
- legacy energy (fossil fuels, oil & gas, coal, nuclear),
- steel industry & metallurgic mining (iron, copper, aluminum, lead, iron, …),
- precious metals (gold, silver, …),
- non-metallurgic mining (Granite, Marble, gemstones, rare-earths, Lithium,…),
- soft commodities (coffee, cocoa, cotton, rubber, cattle),
- timber/wood/paper,
- chemicals (fertilizers/pesticides, speciality chemicals, …)
- Defensive and high earnings-stability industries:
- Consumer staples (-non-cyclicals): Household products, tobacco, food, alcohol, beverages, cloths, stationery, detergents, supermarkets, convenience & low-cost stores, gas stations, …
- Insurance (general & health-); typically part of the ‘Finance” sector but thematically fits better with healthcare
- Healthcare staples (Big Biopharma/-tech companies, medicine/drugs/-stores, generic pharmaceutical manufacture & distribution, managed living,…)
- Utilities: Supply/distribute basic amenities: Water, telecom-infrastructure, electricity, sewage, dams, etc.
- High dividend yield (e.g. at the time of this writing IBM, KO, LLY, GILD or AMGN)
The more of these you see outperforming while there is a lack of risk-on leadership, the more unlikely it is that in the immediate future you’ll see a great and strong market up-trend heralded by them.
Here, if there are any strong leading stocks in those environments from the risk-on segment at all, they will commonly be few in numbers, have no group confirmation, and trade so volatile that the risk of entering them is very high.
Risk-on segments outperforming earlier in cycle
As was touched upon during the earlier guide on stock selection, there are sectors and industries that are more prone to birth innovative and young growth stocks, whose outperformance are usually seen earlier in the stock market cycle and herald stronger and more healthy market environments and up-trends.
These risk-on segments include:
- Consumer discretionary stocks / retail:
- people are able afford to buy products and services that are not essential, i.e. discretionary if their purse allows it:
- clothing, furniture, high-end electronic retail, automobiles retail/manufacture, luxury retails, Travel, air-lines,
- hospitality, department stores, hotels, restaurants, Homebuilding & private construction (not REIT)
- people can afford to buy new cars, upgrade homes, shop, travel, eat out, buy non-necessary indulgences/luxuries, etc.
- people are able afford to buy products and services that are not essential, i.e. discretionary if their purse allows it:
- (Information-) Technology, including some communication services/equipment:
- novel packaged software & digital services,
- novel & high-end consumer electronics & hardware,
- innovative goods & services for the house or business environment,
- novel semiconductors, CPUs, GPUs, hardware, storage, peripherals,
- novel communications equipment & services (excluding basic & legacy infrastructure & utilities)
- novel renewable energy technologies (solar, wind, H2, …)
- note: Technology always refers to something novel that solves a new or current problem in business or everyday life. Technology can be pretty much anything as long as it fits these criteria, and many past innovative technology stocks became cyclicals once the problem solution became generally accepted
- Life Sciences, Biotechnology, Healthcare equipment:
- technically a sub-section of technology (i.e. a novel problem solution)
- new and innovative products/services/medicines/equipment from the biotech-, biomed-, or healthcare industries, for example:
- surgical devices or robots,
- medical transport devices, organ transplant technology, monitoring devices,
- direct or auxiliary novel treatments, therapies or pharmaceuticals as for intervention, cure, therapy or recovery from disease or sickness,
- etc.
Some industries will have overlay and apply to multiple sectors – e.g. electric car-makers are both technology and consumer discretionary. Use your best judgement and focus on what the company is known for to decide.
Most leading stocks will come from these fields, at least they have done so for the last few decades. If you see sector rotation into these sectors/industries, most likely accompanied by a wave of emerging powerful leading stocks from these groups, the likelihood of being near a restarting stock market cycle is very high.
Remember, these industries will morph or change sooner or later over the decades – in the early 20th century, utilities and railroads were the hot thing of the day. It’s not impossible that the IT sector will lose it’s badge as the ‘growth sector’ to some other field in the future that is yet unknown or niche.
What does ‘relative outperformance’ mean, and how to spot it?
When looking at what sectors/ industries are outperforming relatively, it’s as simple as looking for stocks that have been rallying over the last 3-6 months, or making new Highs (1-year Highs is sufficient), compared with the backdrop of all the other industries in the market.
Look for ETFs (a set of relevant sector ETFs shown in the graphic above), but better for groups of stocks that are turning up from month- or year-long Lows, break trendlines, reverse downtrends or lift out of month-long sideways trading ranges, start trending up, or many stocks of a group making new Highs in price.
There is a myriad of ways of visualizing sector rotation, from rotational and seasonal graphs and others, but the bottom line is that you should get an understanding from where money is flowing out of, and where it is heading – at least for the moment. Of course, it won’t stay there forever, sometimes sectors go out of favor quickly again once they outperformed relatively.
See here a couple of basic examples of how temporarily outperforming sectors can look at the example of some sector ETFs in 2022:
Just keep an eye on a handful of important sector and industry ETFs over some months, and you will start seeing patterns.
Additionally (or instead!), it can also be very useful to have a list of stocks sorted by sectors and industries, and watch them over the months and years – you will undoubtedly be able to spot group moves more easily.
As a rule you want to always keep the top liquidity 5-8 stocks of every important industry on that list. It’s not worthwhile to suggest here individual stocks of each sector/industry because they change over time.
Feel free to adjust these to your liking, which will also help you understand sectors and industries better.
Caveats
Information gained from sector theory is often very coarse, long-term (tops and bottoms in the cycle can stretch many months and longer), and contains a whole lot of aberrations and noise, especially from heavy-handed interventionism of governments using industry regulation, and monetary & fiscal policy changes.
Thus, only broad group trends and phenomena should be paid attention to.
As well, market cycles take a long time to proceed and reset. Not every market top and long-term down-trend / bear market is due to a recession, not every secondary reaction is due to economic problems, and not every up-trend or rally marks a new cycle. The stock market is influenced by a myriad of basic conditions – and only following institutional money and their piling money into risk-on leading stocks can reliably tell us where the market is at.
However, sector theory gives us yet another piece of information to gauge market health with – another puzzle piece to look for the greater picture.
