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As an investor planning for retirement, you might wonder if there is an ideal segment of the market or economy to invest in. Is there an optimal strategy that can help you jump into the strongest asset or asset classes during different phases of the stock market cycle? 

You may be aware that certain categories of stocks tend to perform better during certain stages of a bull market. You might also be aware that stock leadership rotates several times within a market’s bull-to-bear life cycle. Knowing this, you may want to find a way to anticipate category leadership so you can profit from it.

In this article, we will look at category leadership, examine general performance through various stages of the market cycle and discuss how investors might approach investing in these categories as performance leadership rotates. But first let’s define some stock market categories.

Stock Market Investment Categories

Some common ways to classify stocks are by the following categories:

  • This category refers to the home country of a stock’s issuing company.

Why is it important? Stocks could be impacted by the overall economic and political conditions of their home countries. When trading shares of a foreign or international company, it might be wise to monitor the fundamental conditions of the company’s domestic economy.

  • This category refers to the size of a company’s market capitalization, often grouped into small cap, large cap, and mega cap. Different sized companies tend to rotate market leadership during different parts of the market cycle.
  • Stocks are sometimes characterized as either value or growth. Value stocks are loosely defined as companies with strong fundamentals but stock prices below those of their peers. Growth stocks are generally expected to grow in value faster than the market average and may sport higher valuations relative to their peers.
  • A sector groups together companies whose businesses, services and products are similar or related. A sector represents a segment of the economy. For example, some well-known equity sectors are Industrials, Healthcare, Financials and Information Technology. Sector leadership rotates during the market cycle. This sector rotation has led some investors to pursue a sector rotation strategy when investing. This kind of sector-rotation strategy is an investment and trading strategy may try to capture higher returns by shifting into and out of sectors based on market analysis.

While some try to invest in recently hot categories or find a permanently outperforming one, category leadership rotates regularly and unpredictably. Even professional traders who study these rotations may find it difficult to time their trades due to unpredictability.

While category leadership might exhibit a few consistent patterns across market cycles, we believe making big bets by investing heavily in a small number of sectors is risky.

Category Leadership Trends Across Market Cycles 

Category leadership exhibits some patterns or tendencies across market cycles, but it can be incredibly difficult to know exactly where in a market cycle you are at any given time. Fisher Investments has done research to uncover some of the following rotational tendencies:

Sector Rotation in a Bear Market

  • Sectors like Utilities and Consumer Staples may perform better during bear markets as typically represent non-discretionary purchases. When the economy weakens consumers still tend to buy groceries, pay their utility bills and use their cell phones. However, more expensive goods or purchases like airfare for personal travel may decline.

Sector Rotation in a Bull Market

  • The start of a bull market may favor stocks that suffered most during the previous bear market. We believe this can happen when certain stocks were punished a more than necessary during a downturn as investors create overly dour expectations. Once the reality doesn’t turn out so bad, those stocks may rebound accordingly.

Size Leadership in a Bull Market

Exhibits 1 and 2 illustrate the difference in performance between small cap and mega cap stocks over the last four bull markets. Exhibit 1 shows small cap stocks tend to outperform mega cap stocks during the first half of bull markets. Exhibit 2 shows the opposite: Mega cap stocks tend to outperform small caps in the later stages of bull markets.

Exhibit 1: Small Cap Stocks Outperform in the First Half

Exhibit 2: Mega Cap Stocks Outperform in the Second Half

Source: FactSet, as of 09/30/2014. Mega cap index is an equal-weighted price index of S&P 500 stocks with a consolidated market capitalization greater than the average weighted market capitalization of the S&P 500, calculated quarterly. Small cap stocks are represented by the Russell 2000 Price Index, a market capitalization weighted index of 2000 US small cap stocks. Graphs depict the average price returns of mega cap stocks (equal-weighted) and the Russell 2000 Price Index during the last four bull markets (10/09/2002 – 10/09/2007, 10/12/1990 – 03/24/2000, 12/04/1987 – 07/16/1990 and 08/12/1982 – 08/25/1987).

Don’t Chase Heat

When a stock category begins to lead the market, investors may be tempted to invest more heavily in that area of the market by trading and shifting their portfolio positioning . We often refer to this practice as heat chasing.

When investors chase heat, they are assuming a given stock or category will continue to outperform based on past performance alone. But past performance doesn’t guarantee future results or profit for you. Chasing heat is risky and it can lead to potentially costly mistakes.

Exhibit 3 shows the rotation of sector leadership from 1999 to 2018. For example, the Technology sector led in 1999 by a huge margin and then lagged for three years before returning to the top. Had you invested heavily in the Materials sector after it had a good showing in both 2016 and 2017, you may have vastly underperformed the market when the sector brought up the rear in 2018. These examples speak to the importance of remaining diversified despite the urge to make big bets.

Exhibit 3: No One Sector Is Best For All Time

Source: FactSet, as of 1/28/2019. MSCI World Sector Total Return Indexes from 12/31/1997 – 12/31/2018. All returns are presented in USD and inclusive of gross dividends.

The rising popularity of exchange-traded funds (ETFs) has made it easier for investors to pursue “hot” sectors or categories. ETFs focusing on particular sectors or categories make it easy to chase heat by trading and purchasing a single fund. But remember, no single category shows predictable longer-term patterns of sustained market leadership.

Chasing heat can leave you vulnerable to unpredictable changes in market leadership by making your investments too concentrated in one or two areas of the market.

Know the Risks

Many investors know to diversify amongst many stocks or bonds. But they may not realize that concentrating their portfolio in one or few sectors or categories can mean taking on much higher risk.

If any of your chosen sectors or categories perform below the broader market, the negative impact of concentrating your portfolio in a narrow market segment can be significant and lead you to vastly underperform.

While making a big bet can yield benefits, it also means taking on higher risk. Regardless of how sure you are, it is always a good idea diversify and hold some stocks you may not expect to outperform the market. We call this a counter-strategy. For instance, suppose you believe the technology sector is poised to outperform. You might consider increasing your exposure to technology yet still maintaining exposure to other sectors to mitigate any losses if your forecast goes wrong.

No one category outperforms others across the entire market cycle. Keeping your portfolio well diversified can help limit volatility and risk.

How Fisher Investments Can Help

Our investing strategy is based on our forward-looking view of market conditions. We don’t chase heat, but we do look for opportunities to take advantage of category rotation, while also minimizing risk. At Fisher Investments, we start by taking the time to get to know you and your situation and then we build a portfolio to help you meet your long-term investing goals. Contact us today to learn more about our services or download one of our educational investing guides.

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Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations.