If you’re interested in playing a sector rotation, consider these strategies before you get started.
The U.S. economy moves in different stages.
There are periods when it either grows or shrinks, and these changes can influence how people invest.
The economy expands when there is an increase in employment, consumer spending and real gross domestic product, or GDP. This is also known as an economic recovery.
An economy contracts when activity slows down or when there’s a decrease in real GDP. In this stage, the economy may experience lower employment and reduced consumer spending.
These economic fluctuations affect the performance of different stock market sectors. During changes in economic cycles, investors should hold stakes in companies that will outperform the overall market and step away from others that may underperform.
If you’re interested in playing a sector rotation strategy, here’s what you need to consider:
- What is sector rotation?
- Strategies for sector rotation.
- The risks of sector investing.
What Is Sector Rotation?
The stock market has 11 different sectors, according to the Global Industry Classification Standard. These include consumer discretionary, financials, real estate and information technology, among others.
These sectors perform differently depending on the phase of the economy. While some sectors may be more receptive to economic growth, others may underperform.
“Sector rotation is the process of selling out of sectors when the economic cycle suggests that their sector may not perform well, and then allocating those investable assets into sectors that are likely to perform better on a relative basis when that economic cycle suggests it,” says Wade Guenther, partner at Wilshire Phoenix in New York.
In the early stages of growth, when the economic cycle is moving away from a recession and into a recovery phase, economic activity bounces back and company profits increase. Sector leaders during this stage include consumer discretionary since people have more money to spend. Financials could also benefit from an expanding economy since interest rates tend to be supportive for banks and other businesses.
During late stages of the economic cycle, investors tend to rotate out of sectors such as consumer discretionary or information technology because some experts say future growth forecasts may be lower than they would be in earlier stages of the economic cycle.
When the economy is performing poorly or enters a recessionary stage, look to defensive sectors such as consumer staples that fall into the categories of grocery stores, pharmacies and companies whose products are used daily regardless of economic conditions. Other defensive sectors, such as health care and utilities, tend to perform well because people still need products like food, groceries and other daily essentials, even in a downturn.
“Health care companies tend to have similar earnings growth patterns across all economic cycles (and have) often outperformed many technology economies in declining or recessionary economic cycles because those revenue streams have been more predictable,” Guenther says.
Revenue and earnings from utility companies are also consistent through different economic cycles.
Even though the stock market is not the economy and these dynamics are not always at play, given historical performance, this is how the market tends to function over time.