Sector rotation is one of the most primordial portfolio strategies at hand for traders and investors attempting to consistently capitalize on broad economic trends playing out in the market. Essentially, the philosophy of sector rotation rests on the assumption that cyclical trends in an economy can and often will influence the performance of particular sectors or industries, for better or worse. The goal when using sector rotation is to anticipate these trends, rotating positions into areas of the market on their ascendance while scaling out of others as they reach their zenith and begin to slow or draw down.
- The traditional conception of the economic cycle has four stages that inform most trader’s approach to sector rotation:
- Early Recovery: low goods prices leading to increased business and consumer spending and slowly rising interest rates; benefits industrial, financial and consumer cyclical stocks
- Late Recovery: high goods prices leading to less business and consumer spending with rapidly rising interest rates; benefits technology, energy and materials stocks
- Contraction: high inventory and low consumer spending coupled with high interest rates; benefits consumer staples, healthcare and utilities stocks
- Recession: slow business growth, production and employment tempered by low interest rates, benefits bonds, consumer
Fund managers and Institutional traders are well aware of these cycles and frequently attempt to get ahead of them by incorporating sectors that perform well in each period, sometimes months in advance. But these periods are fluid, and the assumptions behind the economic activity that occurs during each aren’t iron-clad, either. However, the common reactions among sectors and financial devices in each of the cycle’s stages do have precedence.
For ETF and leveraged fund traders, incorporating sector rotation into their portfolio strategies can offer a crucial edge when the economy does cycle into a new phase.
Let’s take the current economic climate as an example. Interest rates have risen slowly in the past 12 months, which indicates a mid-stage recovery environment that tends to benefit industrial stocks. A glimpse at S&P’s Industrial Select Sector Index and the Direxion Daily Industrials Bull 3X Shares (NYSE:DUSL) which tracks the index bears out part of this assumption in recent market trends.
However, Consumer spending is another indicator that might skew your own perception of which phase of the cycle the economy is in. According to the Bureau of Labor Statistics annual Consumer Expenditure Survey and the University of Michigan’s monthly Survey of Consumers, people are still spending at a healthy clip. This suggests more of an early recovery phase. With this, some traders might anticipate future growth in something like the energy sector.
Crude prices have remained at historical lows for the better part of 2017 amid a glut in inventory, even though the traditional assumption is that increased production leads to increased demand, at least during the recovery phase of the economic cycle. The point is that the business cycle is not gospel, and other mitigating factors can have a substantial influence.
What ETF traders should remain fluent on is what these mitigating factors might mean for future demand. This is how institutional traders or money managers are thinking about their portfolio allocation. Remaining in that headspace alone can put you one step ahead of major shifts in the economic and stock market environment.
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