The concept of sector rotation was briefly discussed earlier in this module. Here we will elaborate it to develop a better understanding of the same.
In the never-ending pursuit to hunt for the next multi bagger, portfolio managers and investors often forget how equities as a whole fit into economic cycles. Globally sector rotation is a highly used term. This term was initially coined by Mr. Sam Stovall, Managing Director of US Equity Strategy at CFRA.
Some investors seek to profit from changes in the business cycle by using "sector rotation strategy." A sector rotation strategy entails "rotating" in and out of sectors as time progresses and the economy moves through the different phases of the business cycle.
Stock Valuations imbibe an element known as forward earnings i.e. the stock prices today are not on the basis of past performance but future expectations of earnings. To put it in other words, The stock price of ABC corporation today is trading as per market estimates of its earnings one year from now discounted at the risk-free rate or cost of borrowing.
The sector rotation strategy calls for increasing stakes and investment allocations to sectors that are expected to prosper during each phase of the business cycle while under-allocating funds to sectors or industries that are expected to underperform. The goal of this strategy is to construct a portfolio that will produce investment returns and outperform the market.
What is sector rotation?
- Sector rotation is a top-down approach style of investing involving movement of money from one industry sector to another by anticipating the various stages of the economic cycle in an attempt to beat the markets.
- It is based on the assumption that certain sectors provide relative strength to different stages of business cycles and thus have the capability to outperform the markets.
- Sector rotation is similar to tactical asset allocation. Instead of investing in a particular asset class—such as stocks, bonds, or commodities—in order to take advantage of current market conditions, the investor constructs a portfolio using selected economic sectors or industries.
According to Peter Lynch, “If you are in the right sector at the right time, you can make a lot of money very fast.” However, the challenge here is to both correctly select sectors and correctly time the economic-cycle – this is a challenging task for most investors. According to Sam Stovall, the author of two books on the topic: ‘Sector Investing’ and ‘Standard & Poor’s Guide to Sector Investing’, different sectors gain in different phases of the economic cycle i.e. expansion and recession.
The image below shows the best performing sectors in different economic cycles:
As market participants we should understand the stock market dynamics and how it is linked to the monetary system. Previously, every stage in an economic cycle used to last for longer periods if we compare it with today’s world. The aggressive monetary policy adopted by central banks around the globe has considerably shortened the length of the market cycle. As a result, 2020 saw the shortest bear market on record. The surging liquidity around the globe gave a shot in the arm to asset prices.
The image below is a representation of some of the sectors which have been trending over the last few years:
The above image depicts that every sector has its own cycle and peaks and bottoms out during the different stages of an economic cycle. As we can see, Nifty Finance rose from FY17 to FY19. Nifty FMCG was booming from FY10 to FY13. Similarly, Nifty Metal has been the star of FY21.
To get started, you can use our Sector Rotation feature. It will help you track the current movement of sectors and identify the right sector to invest in.