Sector Rotation Strategy Based On The Business Cycle

Investors who want to beat the market should be followers of the business cycle. The business cycle is a long-term pattern of changes in Gross Domestic Product (GDP) that follows four stages: expansion, prosperity, contraction, and recession. After a recessionary phase, the expansionary phase can start again.

Business Cycle Phases

The phases of the business cycle are characterized by changing employment, industrial productivity, and interest rates. Some economists believe that stock price trends precede business cycle stages. As a result, the phases of the business cycle provide the strategic framework for economic activity and investing. The business cycle affects employees, employers and investors. For example:

·         The economy is strong; people are employed and making money. Demand for goods -- food, consumer appliances, electronics, and services -- increases to the point where it outstrips supply. This demand fuels a rise in prices, or inflation.

·         As prices increase, people ask for higher wages. Higher employment costs translate into higher prices for goods, fueling an upward spiral effect.

·         When prices get too high, consumers decide goods are too expensive and demand decreases. When demand decreases, companies lay off workers because they do not need to make as many goods or provide as much service.

·         Decreasing demand fuels declining prices, which means the economy is in a recession.

·         Lower prices spur demand. As demand picks up, people begin buying again, fueling the need for greater supply. The cycle goes back to the beginning.

Government Intervention

When the business cycle does not run smoothly, it can have consequences as disastrous as the Great Depression. That is why governments intervene to try to manage the economy. For example, if it appears that inflation is rising too quickly, the Federal Reserve (the central bank of the U.S. charged with handling monetary policy) may decide to raise interest rates to curtail spending. On the other hand, if the economy is performing poorly, the government may lower taxes and increase spending to spur consumption and investment.

Interest rates and the yield curve play a very important role in determining economic activity and the performance of the stock market. Higher interest rates increase the costs to businesses and individuals. Companies must pay more to borrow money for capital investments or to fund daily business operations. Individuals pay more for mortgages as well as other loans they may take out to purchase products. Higher interest rates also increase the demand for money to invest in bonds taking money that could or was invested in the stock market.

The yield curve is a plot of the yield on bonds with the same credit quality across different maturities. The basic assumption is you get more interest on your investment in a bond by holding it longer. The theory states there is more risk for holding a bond for 10 years than for 5 years, or for 5 years than for 90 days. Bloomberg provides a current chart of the yield curve for U.S. Treasuries at Bloomberg, an interesting interactive model of the "living" yield curve.

Implication for Investors

The business cycle has implications for markets and investors. Broadly, a recession often corresponds with a sustained period of weak stock prices, or a bear market. A healthy, expanding economy that keeps inflation from rising too quickly often corresponds with a bull market, or period of sustained market growth.

Fortunately, there are investment strategies for all parts of the business cycle, thanks to the diverse economy we have. Companies that do well when the economy is experiencing good times are called cyclical stocks. Industries that fall under this group include travel and leisure companies, airlines, consumer electronics firms and jewelry makers. Companies that make goods that are necessities, such as food and health care are called non-cyclical stocks. These stocks tend to provide more stability during an economic downturn. During an economic expansion, one should invest in cyclical stocks. On the other hand, during an economic contraction one should consider investing in non-cyclical stocks.

Sam Stovall's Sector Investing, 1996 states that different sectors are stronger at different points along the business cycle. Be forewarned, this is a very expensive book, however it is worthwhile, as it is the best explanation of sector rotation.

The hard part is to identify phase of the business cycle. As you might realize, this is no easy matter and many economists get it wrong. Many indicators are published on a regular basis that people use to monitor the economy. Unfortunately, there is not a simple way to make this strategic decision. The best policy is to try not to predict the business cycle, but rather to monitor the economy looking for signs that it is change in leadership. This change takes several months, so you have time to make your assessment. Keep in mind that the stock market is a leading indicator and will attempt to forecast that the economy is beginning to level off or contract and pull back. Unfortunately, these can be false indications as well.

Sector Rotation Strategy

As an investor, I seek to understand where we are in the business cycle to help guide me where to look for opportunities. However, I do not try to forecast the cycle since I realize I am no better than many economists who make it a full time job to make these predictions. Sector rotation can produce excellent opportunities and must be carefully examined when evaluating the business cycle. Just keep in mind that many investors and gurus are wrong when they claim that we are entering a new stage in the business cycle. Fortunately, one strategy works and is simple to implement.

Identify the most significant fundamental factors that influence each sector. For example, in healthcare, the aging population and expansion of healthcare coverage by the U.S. government are major drivers for the sector. These factors should help push the healthcare to be one of the top sectors. Each sector has their factors that are the major drivers. This type of review gives improves your chances to identify which sectors have the most potential and which ones do not. Using this type of analysis, you can rank each sector based on its fundamentals.

A sector tends to stay in a trend for a number of months. Moreover, when a sector starts to trend, up or down, it tends to stay in that trend for many months. Using technical analysis, you can see the trend changes in each sector, as well as, compare the performance of all the sectors over different time periods. This gives you a view of the sector that are leading and the ones that are trailing. You can also rank the sectors based on your technical analysis.

Finally, you can combine the fundamental and technical rankings into a blended order that provides a simple way to see which sectors are expected to do well and which ones are not. Moreover, if you maintain this list over time adjusting for changes in the ranking factors, you can see which sectors are improving and which ones are falling back. This gives you an opportunity to anticipate where you should start to place capital and where you should start to close out positions.

The Bottom Line

The business cycle offers investors a good way to beat the market. A sector rotation strategy that follows the business cycle, offers an excellent way to align one’s portfolio. It also provides a way to create some diversification, since you should invest in several sectors that span the current stage of the economic cycle, rather than just one. This provides your portfolio some diversification while still following the sector rotation model.