Why Sector Rotation is Better Than the Business Cycle

Look at this graphic…

See larger image

It shows one complete market cycle: a trough (or valley) on the left, a peak in the middle, and another trough on the right.

As you can see, some sectors perform best heading into market peaks, while others perform best heading into market troughs.

And that’s the basis of a sector rotation strategy.

After the stock market peaks, the Consumer Staples (XLP), Health Care (XLV), and Utilities (XLU) sectors typically outperform the market.

Once the market has bottomed, typically it’s the Technology (XLK), Financial (XLF), and Consumer Discretionary (XLY) sectors that lead the recovery.

Likewise, in a strong bull market, the Industrial (XLI), Materials (XLB) and Energy (XLE) sectors are usually the strongest performers.

Knowing just two things — where we are in the current cycle and which sectors perform best during that stage — can give you a significant edge in the market.

Of course, with investing, timing is everything…

If you’re the type of investor who likes buying stock and selling a year or more later, the traditional business cycle model may work well for you. If you prefer being out of the market at the close of each day, like a day-trader, it will be mostly useless.

Personally, I focus on swing trading — meaning, I usually hold investments for a couple of months.

I’ve found that this is the sweet-spot time frame. It’s long enough for market moves to develop. And it’s short enough so that I’m not at the mercy of an earnings report that’s several quarters into the future.

So with my goal of holding investments for a two- to three-month window in mind, I simply focus on sector rotation patterns that match that duration.

The business cycle model takes several years to play out. But these same sectors rotate in and out of favor over shorter time frames, too. Analyzing these shorter cycles allows me to be nimble. I can hop on a hot Energy sector for a couple months in the summer, and be out by September. Then, I can invest in the Consumer Discretionary sector heading into the holiday shopping season, and be out by January.

During the first quarter, the Utilities (XLU), Health Care (XLV), and Materials (XLB) sectors were top-performers, gaining 9.2%, 5.5%, and 2.3%, respectively. And according to the sector-ranking algorithm I use in Cycle 9 Alert, the Energy (XLE), Utilities (XLU), and Consumer Staples (XLP) sectors are showing the strongest momentum, relative to the S&P 500.

All of these observations are suggestive of a mature, possibly “toppy,” market when put into context with the sector rotation model. So too is the fact that Consumer Discretionary (XLY) stocks were the worst-performing in Q1, down 3.2%.

But even if investors are rotating out of the Technology (XLK) and Industrial (XLI) sectors, and into traditionally “defensive” sectors, it doesn’t mean the market will crash tomorrow.

As I wrote about last week, more than 80% of stocks in the S&P 500 are trading above their 50-day and 200-day moving averages. That suggests the market’s internal strength is still intact… and it could be awhile longer before we see the market crack.

Either way, through Cycle 9 Alert, we make hay while the sun shines, using sector rotation to invest in the market’s hottest sectors.

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Categories: Cycles

About Author

Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.