Brief Overview of Sector Rotation Theory

Jun 22, 2007: 2:00 PM CST

“If you are in the right sector at the right time, you can make a lot of money very fast” –Peter Lynch

Sector Rotation Theory can help you invest (or trade) in the key sectors that are outperforming the market right now. There are always stocks in certain sectors that are “on fire” or “out of favor” and you can build a simple hedged portfolio (or trade structure) that takes advantage of understanding the following concepts.

Your goal is to understand broad patterns that reoccur and try to find connections between ideas and occurrences in the market and the broad economy. The stock market can at times lead the general economy and provide high-probability trade ideas for longer term positions (or tell us when to be in bonds and away from most equities).

The following explanation is adapted by me from Peter Navarro’s brief work “When the Market Moves, Will You Be Ready?“($13.57 at Amazon.com)

Recall that the “stock market cycle” often leads the business cycle by three to six months. At the top of the cycle (late expansion), the business cycle is in full expansion and inflation pressures are increasing. The Federal Reserve must raise rates which hinders the ability of businesses to borrow money, and often this leads them to cut back, especially if they foresee consumers less willing to spend on big-ticket items. Often the Fed raises rates too quickly and brings things to a halt because it can take months for the economy to feel the effect of a rate hike.

Assume that the businesses cut back and consumers are crunched and are not spending as freely. Assume that the economy is just ahead of a recession (negative GDP growth). Production falls, employers cut back on labor, factory inventory builds up, prices decine, laid-off workers spend money only on the basics; as such, they cannot purchase big ticket items (new homes, new cars) , and the Federal Reserve begins to step in to correct the situation by lowering interest rates to stimulate growth. Defensive sectors (consumer staples) will outperform when it seems everything is falling (realize they may fall too, just not as much).

Jumping ahead through the recession, interest rates will eventually fall to an attractive rate as the economy ’spirals downward’ and then businesses will begin to expand again and take on more loans and hire new workers and invigorate production. Automobiles and housing stocks may be among the first to recover as consumers have been saving up their money and find interest rates attractive (they were among the first to fall at the market top, also). This also bolsters financial companies and banks who make loans to these consumers at this time – the broader economy is picking up.

As the economy recovers, transportation and technology stocks rise with a brighter future on the horizon and businesses must invest in new equipment/repairs with increasing capital and demand. Sectors such as capital goods, industrial machinery, basic electronics, etc begin to outperform as businesses rely more heavily on them and consumers perk up with demand.

Inflationary pressures are rising, but not to any level of concern as the market and economy rise together. However, increased demand pushes up energy prices (excess production and transportation) and the Federal Reserve has been raising interest rates to keep inflation in check and eventually consumers will again be pinched by rising prices and high interest rates (as will businesses) and the cycle will reach the peak and begin afresh.

While no two cycles are equivalent, the underlying theory – which is explained in much more detail and clarity by Dr. Navarro – remains valid and sufficient to build trading ideas and positions for underlying profit regardless of your strategy. Examine this concept in more detail if possible and realize it has great potential to make sense of some of ‘technical analysis’ and underlying fundamental currents that drive price.

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4 Comments

4 Responses to “Brief Overview of Sector Rotation Theory”

  1. Bill Kemperman Says:

    Corey -
    I have started the book by Martin Pring – The All Season Investor . Same theory . It , I must admit ,is a very technical read , ( for me anyway) and I’m having trouble grasping all he has to say the first read through . He really is strong on Bonds in first half . I may also check out Mr. Navarro’s book . Thanx for the jog on the importance of knowing what cycle leg we are in . Bill K.

  2. Corey Says:

    Martin Pring is an amazing instructor with a deep wealth of knowledge. I have heard him speak on three occasions and during a lengthy presentation, he was introducing the book and material you refer to. The theory – you’re right – is the same but the level of detail and depth/complexity can be varied depending on the instructor or source.

    Dr. Navarro is much more geared ‘to the public’ with anecdotes and ‘readability,’ yet light on depth, while Pring is quite the opposite. After all, he is referred to as the “Technician’s Technician.”

    Thanks Bill!

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