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Home » Model Portfolios » Sector Rotation Strategy » Theoretical Aspects
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Sector Rotation Strategy - Theoretical Aspects

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Theoretical Aspects of Sector Rotation Investing

The Basics

The basic idea behind a sector rotation strategy is that economy operates in repetitive cycles. An economic cycle is generally divided into four stages: early expansion, late expansion, early recession and full recession. The stage in which an economy operates has a significant impact on the profitability and prospects of different sectors (a sector refers to a group of stocks representing companies in a similar line of business or industry).

 

For example, consumer staples or the health care sector is considered to be defensive, meaning companies in this sector are generally unaffected by economic fluctuations. The health care sector consists of pharmaceutical firms, biotech firms and medical equipment suppliers. The demand of such products is fairly steady and these companies are not affected by rising or falling interest rates during an economic cycle. Therefore this sector is considered to be very defensive and it mostly outperforms the market during an economic contraction.

 

Therefore various sectors become more or less attractive at different stages in the economic cycle. So in other words, at various stages in an economic cycle, certain sectors will outperform and other will underperform the underlying market.

 

Select Sector ETFs Yearly Performance

 
Select Sector ETFs Yearly Performance  
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ETF SPDR Universe Overview

  • S&P 500 Index ETF (IVV)
  • Con. Discret Select Sector SPDR (XLY)
  • Technology Select Sector SPDR (XLK)
  • Con. Staples Select Sector SPDR (XLP)
  • Industrial Select Sector SPDR (XLI)
  • Materials Select Sector SPDR (XLB)
  • Energy Select Sector SPDR (XLE)
  • Health Care Select Sector SPDR (XLV)
  • Utilities Select Sector SPDR (XLU)
  • Financial Select Sector SPDR (XLF)

 

 

 

 

Sector Rotation in a Stock Market Cycle

Recall that financial markets often lead the economic cycle by three to six months. That means that the stock market cycle is usually well ahead of the economic cycle. The stock market tries to anticipate each new piece of economic information that is released and respond to it. Therefore bull markets begin often before a period of early expansion and that bear markets begin before a period of contraction. For example at the top of a late expansion, the economic cycle is in full expansion and inflation pressure is increasing. Central banks must raise interest rates which hinder the ability of companies to borrow new money for new rewarding projects or takeovers.

 

For example, consumer discretionary stocks, which are most attractive during the early stages of an early expansion of the economic cycle when consumer demand begins to build. Therefore sector rotation is a proven investing strategy that can make a significant difference in the performance of your portfolio.

 

 

Stock Market Cycle leads the Economic Cycle by 3 to 6 Months

The graph below shows the relationship between the economic and the leading stock market cycle. Additionally this graph should act as simple roadmap for investors to pinpoint those sectors which should benefit the most during various stages of an economic cycle. Recall that financial markets often lead the economic cycle by three to six months. That means the market cycle is usually well ahead of the economic cycle. This is important to remember; for example as the economy is in the lowest point of a recession (full recession), the market begins to look ahead to a recovery (bull market).

 
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