The economic cycle is when the economy moves
from growth to recession and back to growth
again.
It's one of the most influential forces
in the stock market.
The economic cycle is significant because
it plays a large role in determining corporate
profits, which are probably the most important
factor that influences stock prices.
Where things get complicated is how the economic
cycle impacts different sectors.
Stock market sectors are sensitive to different
stages of the economic cycle.
Simply put, some sectors may outperform when
the economy is growing, while others may outperform
when the economy is in a recession.
The varying performance is something that
investors refer to as sector rotation.
Sector rotation is driven by investors buying
and selling different stocks during the economic
cycle's stages of growth and recession.
Let's look at an example of how sectors
typically perform throughout the economic
cycle.
Let's suppose that the economy is emerging
from a recession.
One of the first sectors that investors usually
move, or rotate, into is Financials, which
includes businesses like banks, brokers, and
insurance companies.
Why?
Toward the tail end of a recession, interest
rates are usually favorable for businesses
such as banks.
Consequently, investors rotate into the Financial
sector when they anticipate a recovery.
After the economic cycle turns up, investors
usually next rotate into the Technology sector.
This sector is sensitive early in the economic
cycle because businesses invest in new technology
to make productivity gains.
As the economic recovery gathers momentum,
investors typically move into the Consumer
Cyclical sector.
This includes businesses like automobiles,
housing, and retail—things that are discretionary,
or nonessential.
Consumers typically grow more confident as
the economic recovery takes hold.
And with the growing confidence can come increased
spending on discretionary items.
After Consumer Cyclical, investors generally
rotate into the Transportation, Industrials,
and Basic Materials sectors.
This is usually considered the midpoint of
the growth stage, which is when these types
of businesses increase production in response
to increasing demand.
As the growth stage matures, investors typically
rotate into the Energy sector.
At this point in the cycle, the Energy sector
benefits from increased demand for transporting
goods during the previous stage of the cycle.
When the economy transitions from growth to
recession, investors may get defensive and
start to rotate into the sectors that are
less sensitive to the economic cycle.
These sectors are sometimes referred to as
defensive sectors because they can offer relative
protection during a recession.
When considering defensive sectors, think
about it this way: What are the goods and
services that you'd keep buying even in
a recession?
Most likely you'd continue spending on things
like food, utilities, and your health, to
name a few.
These are typical examples of goods and services
supplied by companies in defensive sectors.
The first sector investors usually rotate
into during a recession is Consumer Staples.
This sector includes companies that make food,
beverages, and household items.
People still need to eat, drink, and clean
their houses during an economic downturn,
which is why investors rotate into Consumer
Staples in the early stages of a recession.
As a recession continues, investors typically
rotate into the Utilities sector next because
gas, electric, and water bills also have to
be paid during an economic downturn.
When a recession worsens, investors might
move into the Healthcare sector because people
are obviously willing to pay for healthcare
no matter what the economy is doing.
Toward the tail end of the recession, investors
generally rotate into the Services sector.
This sector includes waste management and
labor staffing.
After rotating into Services, the economic
cycle usually starts over again, and investors
might rotate back into Financials in anticipation
of growth and the end of the recession.
So how can you identify the sectors that are
rotating in and out of favor under the ideal
circumstances that we've covered?
You can start by watching price trends among
the different sectors.
If an economic recovery is well underway,
look for new upward trends to emerge in the
Transportation, Industrials, and Basic Materials
sectors.
Conversely, in the middle of a recession,
look for new upward trends in sectors like
Utilities and Healthcare.
Being aware of sector rotations can help active
investors adjust their portfolios.
And although there may be indications of a
sector coming into or moving out of favor,
remember that it's difficult to predict
with certainty and try to look for confirmation
when possible.
For example, if an active investor observes
that a sector might be coming into favor,
she might hold existing investments in the
sector or look for new opportunities in that
sector.
On the flip side, if she observes a sector
seems to be going out of favor, she might
raise stop losses or sell holdings within
that sector to cut losses or lock in profits.
Applying sector rotation in these ways can
help investors manage a portfolio and even
present new opportunities.
But, sector rotation takes some time and experience
to learn.
It's a good idea to go through at least
one economic cycle and observe how investors
rotate from one sector to the next at each
stage of the cycle before making your own
decisions based on sector rotation.
