Introduction to Sector Rotation
As we know, a business cycle manifests itself in four stages: Expansion, Peak, Contraction & Trough (more on this later). Stock Markets are a leading indicator of economic health and hence valuations are correspondent to stages of the business cycle.
Sector rotation is important to stock market investors because certain sectors perform well in a particular stage of the business cycle, while others do not. If we can assess the possible performance of each sector during each phase of the market cycle, it will be easy to select the stocks. Once that phase of the economic cycle is over, we can shift the invested money to another sector that is suitable for the next market cycle.
A sector is a group of similar industries or companies that have a common trait. Dividing an economy into different sectors can help us to analyze and compare them in a better and sensible manner. It is imperative to note that each sector has unique characteristics as well as risk profiles.
Stocks can be classified into sectors based on the products/services they offer. For example, the Chemical Sector will have the companies which produce chemicals. Similarly, the Automobile Sector will have the companies which produce automobiles or its parts.
Additionally, the demand supply dynamics are also crucial to understand. For instance, a good monsoon is considered as a positive sign for agriculture related stocks such as pumps, tractors, fertilizers, etc. Similarly, monsoons are a lean period for cement & construction companies . Hence, understanding the key drivers of the stock is a prerequisite for mastering the art of sector rotation.
Every sector has suitable valuation metrics attributed to it as per its growth prospects, competition, entry-exit barriers and different economic realities. There is no one size fits all approach when it comes to deciding appropriate valuation metrics. For instance, The Price to Earnings Ratio (P/E) may be suitable to value a consumer goods company but it would be unwise to use the same to determine valuations of Banking & NBFC stocks.
It has often been seen that weak stocks in a sector benefit from a favorable regulatory/economic environment. The overall positive buzz surrounding the sector propels the stock to perform well. On the other hand, if a sector is underperforming for quite some time, a good stock belonging to the sector with an excellent track record as well as management prudence, may still fail to generate wealth for investors.
Analysts use two types of approaches for analyzing a stock, namely the Top-Down Approach and Bottom-Up Approach.