Sector rotation may seem like a more advanced topic to those of us that are reading this for the first time, sectors are a part of the stock market, and each sector is affected by overall monetary policy conditions and economic conditions differently. This means some sectors do well in strong economies, some do poorly. This knowledge allows us to infer where the market is headed and turn that into a profit!
Throughout this post, we’re going to dive deeper into sectors, how they rotate and how you can make money from these rotations.
We are going to go through the following:
What is a Sector Rotation
First, the easiest part of this article, explaining a sector, before we run into some trouble. A sector is a group of companies that all provide the same or similar services or goods. The simplest breakdown are the 11 sectors of the S&P 500 which we will discuss later on.
A sector groups companies together based on what their general output is. For example, let’s take the financial sector, within are companies that provide financial services or goods. Such as; banking, insurance, data protection, payments, statistics, online transactions and so on. Some of the larger financial names you might know that are in this sector are: JP Morgan, Berkshire Hathaway, Paypal, American Express, MasterCard, Visa, Bank of America. Etc The list goes on for a long time!
What Are the 4 Market Cycles?
Typically stocks don’t move in lockstep with the economic cycle, rather they move in anticipation and reaction to the economic cycle. Meaning some stocks move before the effects of the economic cycle come into play and others move after. The market can be split up into 4 different cycles:
- Market bottom: the low point on a longer scale has been reached in the market
- Bull market: markets start to rally from the lows and continue higher.
- Market top: the high point of the market, where the bull gets exhausted and starts to pass out.
- Bear market: The downside of the market, where we continue lower and lower.
The average bull market lasts about 3.8 years, while the average bear market lasts about 10 months.
The common question is, how can we find where there are market tops or market bottoms? It is a hard task However, sector rotation and understanding market internals can help with this. Understanding what the exhaustive market volume to either end is…
Sector rotation can identify when big money starts moving from risk to risk-off. We will cover this throughout this post.
What are the 4 Economic Cycles?
The economy is at the lowest point in its life. At this point businesses and job-seekers are in desperate trouble. The technical qualifier for a recession is: GDP or gross domestic product contracting/ falling for two consecutive quarters. The yield curve starts to stabilize, interest rates are at rock bottom and there is a recovery scenario on the horizon. Where the following sectors start to profit the most:
The economy starts to pick up, there is a steepening of the yield curve, jobs are starting to come back slowly but surely, consumer expectations are starting to increase and interest rates have met their bottoms. Industrial production starts to ramp up again The following sectors profit the most from this point in the cycle:
- Basic Materials
Economic internals start to shift, we have rising rates, a little faster than would’ve possibly liked. The yield curve begins to flatten, consumer expectations start to fall. Products really fall off and even flatlines. The most profitable sectors in this time historically are:
- Consumer staples
This is when the economy starts to look really bad again, consumer expectations fall to ground 0. Interest rates are at highs, the yield curve can be inverted, and if it’s not, it’s flat. Industrial production has fallen a lot. This is a historical reading of what usually happens, overall there can be differences in how this plays out. In 2022, there are a lot of economists talking about recession and how we could be in a massive bear market. However, the above conditions are NOT all there.
For example, the rates are not at highs currently. Historically, the sectors that perform the best in this environment are:
- Cyclicals & industrials
Here is a little cheat sheet of different assets and how they perform in a business cycle from stockcharts.com. (All credit goes to them).
What Are the Main Market Sectors?
In this section, I want to brief on different asset classes and how they’re affected, rather than going too deep into the actual sectors, which is a part of the next portion. We will talk about equity sectors.
If you look at the cheat sheet above, you probably already know the three main sectors that we look at in the economic cycles and business cycles. They can be split into:
- Bonds (risk-off)
- Stocks (equities/risk on)
- Commodities (inflation hedge/partial risk-off)
Within each of these, there are more categories and it’s not as simple as “equities do well as the economy expands”. Or “bonds do well in contractionary environments, buy bonds when equities are down”. This in theory does work and used to work back in the day. However, now there are different internals that one has to consider. Such as interest rates and yields, they’re not “typical” in falling environments.
What Are the 11 Sectors in the S&P 500?
The S&P 500 can be divided in 11 sectors, each holding a different weight. Realistically money rotates in and out of these sectors based on what is going on in the economy. Money managers cannot afford to hold too much cash, as people pay them to be invested in the markets. This is where sector rotation and asset rotation come from.
The 11 sectors in the S&P 500 and their weights are as follows:
- Technology 27.68%
- Health care 13.80%
- Consumer Discretionary 11.90%
- Financials 11.43%
- Communication Services 9.33%
- Industrials 7.97%
- Consumer Staples 6.03%
- Energy 3.93%
- Real Estate 2.68%
- Utilities 2.65%
- Basic Materials 2.61%
These sectors break up the overall equity market and get money flowing into them and out of them based on anticipated market cycle movement.
Trading & Understanding Sector Rotation
Trading and understanding sector rotation is a little more complex, you can have an idea based on the 4 economic cycles, but realistically, in a bear market, no individual stocks are going to perform well. There will be times where certain sectors do well and that is in transition periods between different markets and bottoming or topping markets.
For example in 2021, at TRADEPRO Academy we noticed a few things, the market was looking top-heavy but also there was money flowing OUT of some sectors and into other sectors. There were also monetary policy shifts from the FED that would lead us to believe certain sectors are going to perform well while others are going to underperform.
Here is a general cheat sheet for sectors in different economic conditions. This is from Fidelity.
Let’s start with the monetary policy shifts and how they affect prices.
Shifts in monetary policy directly affect the stock market and cycles of inflows. For example, by the end of 2021, there was a really high inflation increase where we were hitting inflation numbers. Meaning to subdue this, interest rates have to be increased. This puts pressure on all assets overall in different sectors. Mainly on technology stocks which do poorly in high inflation environments and increasing rates. Because they are long-duration assets.
However, do you know which stocks do well in higher interest environments? Generally, financials and banks, their revenue increases. Which is what we saw to start 2022. Increase in financials from money flow and decrease in technology. Other than some main names like AAPL and MSFT. There are names within poor sectors that do well. Like AAPL and MSFT were flown to as safe-havens. Where a lot of managed money was parked while the market internals started to shift to the bearish side.
Now for the sector movement based on flow, we noticed at the end of 2021, that energy is going to have a really good first quarter in 2022. The flow of money into sectors can be found in order flow platforms and tools, just like Unusual Whales. This platform tracks the money flows of sectors and the largest stocks in that sector as they start to accumulate or start to flow out. Take the following example into consideration.
From here you can see the inflows and outflows and the changes in inflows in each of the 11 sectors of the SPY or S&P500 index. They’re both compared to the previous day and one another. Along with 3 months of backtesting inflows and outflows.
Generally, when traders see an outflow of technology, which is the largest sector in the market, there is little pressure for the overall index to continue rising. Outflows in technology, communication services, and financials usually lead to trouble in the markets. Inflows into energy, health care, basic materials, and consumer defense usually confirm the previously stated hypothesis. Traders and investors alike have to be aware of the weight that each of the sectors holds as well, some are more influential than others.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.