Sector Rotation

As an investor planning for retirement, you might wonder if there is an ideal segment of the market or economy in which to invest. Or maybe an optimal strategy that can help you find the best security or jump into the strongest asset classes at just the right phase of the stock market cycle?

Historically, certain categories of stocks have tended to perform better during certain stages of a bull market, and stock leadership rotates several times within a market’s bull-to-bear life cycle. Knowing this, it’s normal to want to find a way to anticipate category leadership to help you position yourself properly for the market cycle ahead.

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

Investors often classify stocks through the following categories:


Country

This category refers to the home country of a stock’s issuing company. This is important because stocks can be impacted by the overall economic and political conditions of their home countries. When trading shares of a foreign or international company, it may be wise to monitor the fundamental conditions of the company’s domestic economy.


Size

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.

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Valuation

Stocks are sometimes characterized as either value or growth. Value stocks are loosely defined as companies with strong fundamentals and typically have stock prices below those of their peers. Growth stocks are generally expected to appreciate faster than the market average. Growth stocks may sport higher valuations relative to their peers.


Sectors

A sector groups together companies whose businesses, services and products are similar or related. A sector represents a segment of the economy. Some well-known equity sectors are Industrials, Health Care, Financials and Information Technology.


Sector-Rotation Strategy

Sector leadership rotates during the market cycle. Some investors pursue a sector-rotation strategy to capitalize on the continual changing in leadership. In a sector-rotation strategy, an investor may try to capture higher returns by shifting in and out of sectors based on market analysis.

Some may try to invest in recently hot categories or find a permanently outperforming one. But, category leadership rotates unpredictably, making it difficult for even professional traders to time their trades.

While category leadership might exhibit a few consistent patterns across market cycles, we believe concentrating your investments 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 difficult to know the exact position in a market cycle at any given time. Fisher Investments’ research has uncovered some of the following rotational tendencies:


Bear Market Sector Rotation

Sectors like Utilities and Consumer Staples may perform better during bear markets, driving bearish investors towards these more defensive stocks rather than toward cyclical stocks. Even when the economy weakens, consumers still tend to buy groceries, pay their utility bills and use their cell phones. However, more purchases like airfare or expensive goods may decline.


Bull Market Sector Rotation

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 are punished more than necessary during a downturn, driven by investors who have overly dour expectations. Once the reality doesn’t turn out so bad, those stocks may rebound accordingly.


Size Leadership in a Bull Market

While not always the case, history suggests that small cap stocks tend to outperform mega cap stocks during the first half of bull markets. The reverse tends to be true in the latter stages of bull markets. However, leadership between these categories is cyclical and rotates irregularly. We deploy a flexible investing strategy based on our forward-looking expectations, instead of adhering rigidly to a single investing category.


Don’t Chase Heat

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

When investors chase heat in the stock market, they are assuming past performance alone will continue to propel a given stock or category forward. But, past performance doesn’t guarantee future results or profit for you. Chasing heat is risky and can lead to costly mistakes.

In 1999, the Technology sector led by a significant margin, but eventually lagged for three years before returning to the top. The same could be said about the Materials sector in 2016 and 2017. This sector led for two years before trailing in 2018, leaving some investors to underperform the market because of overconcentration in what once was a “hot” sector.1 These examples speak to the importance of remaining diversified, despite the urge to make big bets.

Exchange-traded funds (ETFs) have made it easier for investors to pursue “hot” sectors or categories. ETFs that focus 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.


Dealing with the Risks


Lack of Diversification

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

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


The Counter-Strategy

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 maintain exposure to other sectors to help mitigate any losses if your forecast goes wrong.

Regardless of how you implement your long-term investment strategy, remember no one category outperforms others across the entire market cycle. Over the long run, keeping your portfolio well diversified can help limit volatility and risk.



1 Source: FactSet, as of 1/28/2019. MSCI World Sector Total Return Indexes from 12/31/1997 – 12/31/2018.


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