Sector Rotation Trading Strategy in the Stock Market
Sector rotation is the attempt of money managers and investors to take advantage of predictable patterns during changing economic cycles.
Before I show you which sectors do best during stock market seasonality, I will need to explain the economic cycle .
Sector Rotation – What Causes Market Fluctuation?
If you take a look at a stock chart on a weekly time frame you will notice that for the most part, stock markets have been moving higher since the start.
The chart below is a weekly time frame of the SP500 (every new candlestick is one week):
SP500 Stock Market Weekly Chart
However, drilling down into a daily chart will reveal fluctuations. Stock market downturns are called bear markets.
When a stock market begins selling off, it closely aligns with the larger economic cycle.
Typically, the US and global economies move in cycles and fluctuations.
Like a wave in the ocean, we move higher then pull back, then higher and back again. Over and over again this cycle repeats.
Economic cycles can be broken into the following categories:
- Expansion
- Peak
- Contraction
- Trough
- Repeat
You can take a closer look at this visualization in the image below.
Sector Rotation – Economic Cycles and Stock Market Performance
Every part of an economic cycle in the stock market has different characteristics. As a result, investors rotate their assets between different sectors to capture the best opportunities while avoiding seasonal weakness. This is why it is called sector rotation.
The chart below, captured from StockCharts.com shows you a typical sector rotation trading strategy.
Now let’s break down this chart a little further.
During a bull market and economic expansion cycle, sector rotation strategies will perform best by purchasing technology stocks. Tech stocks will grow the fastest in a growing market, which has been witnessed in the most recent bullish run.
As you may have noticed, Facebook, Apple, Amazon and Google (called FAANG) have been leading the way higher in the equity market.
In the weekly chart below, you can see that FANG stocks returned 378% since the start of 2013. Meanwhile, the SP500 (orange line) only returned 87.71% in this same time period.
This is an example of sector rotation into a bullish market.
Sector Rotation – How to Trade Market Tops
Early signs of an economy peak are seen when energy markets break out move to the upside. Looking at a recent chart of oil is evidence of this type of move in today’s market conditions.
So what would be a good course of action to capture the contraction phase of the economic cycle?
Sector rotation into healthcare, consumer staples and utility companies.
This can be accomplished by purchasing a series of ETF (exchange traded funds) to give you exposure to all stocks in a market sector.
One way to invest in consumer staple stocks is by using the XLP ETF. XLU is for utilities, while XLB is the materials sector.
Sector Rotation Conclusion
Stock market and economic cycles are an opportunity for the informed investor and trader. You should embrace volatility and cycles rather than fearing them.
Professional traders and money managers are busy utilizing these sector rotation tricks.
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For now, have a great day and enjoy your new sector rotation tool – it can help you create a well diversified trading strategy to take advantage of market timing.
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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 to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
