Sector rotation is an investment strategy designed to take advantage of the fact that companies in different types of businesses typically provide stronger returns at certain times than they do at other times. To the extent you can predict when the strong period for a given sector will be, you can profit from being invested in that sector from the beginning of the period.
Putting a sector rotation strategy into practice is generally easier using mutual funds and exchange traded funds (ETFs) than it is trying to identify individual investments in the appropriate sector or sectors. Though there are differences between the two types of funds that may affect the costs of buying, holding, and selling as well as determine the precision with which a sector or subsector is defined, either type may serve your purpose.
A technical approach
Using a technical approach to sector rotation, such as the one described by Sam Stovall of Standard & Poor’s, you determine the relationship between the phases of the full economic cycle—full recession, early recovery, full recovery, and early recession—and the market cycle. The market cycle tends to run ahead of the economic cycle, so stocks lose value because investors anticipate a recession, turn bullish in the very early stages of an economic recovery, hit a new top before the economic cycle has fully recovered, and turn bearish while the economy is still strong.
In theory, at least, different market sectors follow different, though overlapping, patterns through these cycles and rebound at different times in those interlocking cycles. For example, utilities have historically tended to prosper in recessionary periods, when consumer expectations and interest rates are falling— though there is no guarantee that will necessarily be the case in future cycles. Industry, energy, and consumer services have tended to expand in bull markets.
Two historical examples that illustrate this pattern occurred in 2000 and 2004. As a bear market took hold in 2000, utilities outperformed all other sectors, gaining 56% according to data from Dow Jones Indexes. But in 2004 and 2005, as the market prospered, oil and gas were on top of the performance charts.
