Time for Sector Rotation?

 

By Nancy Zambell,

Editor of Investment Digest and Dividend Digest

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Is it Time for Sector Rotation?

Economic Cycles and Sector Performance

Sectors that Benefit in Various Market Cycles

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Like many analysts who went to business school at the same time I did, for many years, I was in love with the idea of “buy and hold.” But after more than 30 years of many market and economic cycles, my investing strategy has adapted to changing times.

That means that markets and economic activity have demonstrated that—over time—certain economic cycles can do a fairly good job at forecasting both bullish and bearish market and sector trends.

In my latest issue of Dividend Digest, I discussed the “Sell in May and Go Away” adage—that time period from May through October when markets usually post smaller gains than the rest of the year. I say, usually, because history never exactly repeats itself. You can read that article here. 

There are dozens of other memorable adages to describe certain market cycles and trends, but today I’d like to focus on a more macro view.

This chart gives you a historical representation of typical economic phases and the sectors that usually benefit during those periods.

The flow chart of a typical economic cycle usually looks like this:

• Full Recession: GDP contracts, interest rates decline, unemployment rises.

• Early Recovery: Production increases, rates bottom, consumer expectations begin to rise.

• Late Recovery: Rapidly rising rates, production becomes flat, consumer expectations drop.

• Early Recession: Production falls, rates rise to a peak, consumer expectations are at their most pessimistic.

The biggest problem in forecasting which sector does well during these cycles is that we don’t have any way of knowing exactly how long each phase of the cycle will last. Consequently, choosing which investments to make—or keep—during those cycles requires a bit more research and analysis.

For instance, in the past year, when many economists would agree that we’ve been in an expansionary phase of the cycle (albeit, slow growth), the sectors that performed the best were:

• Healthcare, up 10.74%
• Communications, up 9.81%
• Technology, up 9.77%
• Basic Materials, up 9.52%
• Real Estate, up 9.24%

Those returns differ somewhat from what the historical chart would lead us to believe. According to the chart, healthcare should perform best in the beginning of a bear cycle, materials during a late bull, and technology during an early bull.

The problem is that this time around, our economic and market cycles are more extended than normal. Our expansionary phase has been slower to get going and has lasted longer than many that have come before, so it’s natural that our bull market phase could also last longer than normal. So it’s no surprise that some sector trends have gotten a bit mixed up.

This research on StockCharts.com, which analyzes current economic and market cycles, seems to be a pretty good fit (although not exact) for today’s sector performance.

The article defines economic stages this way:

Stage 1: Slowing growth rates or early recession. Interest rates start to fall and bonds rally.
Stage 2: Business cycle trough. Stocks begin to rally.
Stage 3: Late recession and early recovery. Commodities begin to rally.
Stage 4: Early recovery. Interest rates trough and bonds peak.
Stage 5: Cycle peak. Stocks peak.
Stage 6: Slowing growth, commodities peak.

The chart forecasts that we are currently in Stage 4, but moving into Stage 5.

We all know that the Federal Reserve will soon begin raising rates, and markets have recently been locked in a trading range. So, now may be the time to take a look at your holdings, with an eye to moving a bit toward sectors that may perform well during the next few stages, which might include healthcare, technology, financial and materials.

I don’t advocate selling out of the rest of your sectors, but rather strengthening your holdings in some of the forecasted better-performing ones for the near term.

And as always, don’t forget to protect yourself by setting price targets and stop-losses.

If you would like help in selecting strong stocks in various sectors, consider taking a risk-free trial subscription to Investment Digest. I scour more than 200 advisories and research reports to select the top recommendations including growth stocks, value stocks, technology, small-caps, biotech, pharmaceuticals, funds, ETFs and more. You’ll receive one top recommendation in your email box each morning. Get more details here.

Sincerely,

Nancy Zambell
Editor of Investment Digest and Dividend Digest


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