The economy moves in cycles. These cycles are classified into four stages namely Full Recession, Early Recession, Late Recovery, and Early Recovery. Certain sectors and industries tend to perform better than others at a particular stage in the economic cycle. The markets also move up and down in cycles and stages just like the economy. The stages of the market cycle are also classified into four stages namely the Bull market, Bear market, Market top, and Market bottom.
The market and the economy are closely linked as the financial markets generally predict the state of the economy. This means that the market cycle precedes the economic cycle. Financial analysts look at both these cycles closely to predict a turnaround. An economy that is under recession generally talks about the beginning of a bull run and so on.
Certain sectors and industries tend to perform better than others at a particular stage in the economic cycle. Sector rotation is an investment strategy used to take advantage of the changes in the economic cycle which directly or indirectly affect the industries and sectors. Investors tend to rotate their funds from one sector to another as the economy progresses and goes through various stages of the market cycle. Effectively more funds are allocated to those sectors or industries that are expected to gain from that particular stage of the market cycle and lesser funds are allocated to those industries that are expected to benefit the least. Using the strategy of sector rotation, an investor aims to create a portfolio that generates returns far greater than the overall market.
The basis on which sector rotation revolves is primarily classified into two main components viz. interest rates and currency values. Inflation and deflation cause a continuous change in the economic cycles and is more or less predictable. The sectors that are historically known to perform well during a bear market are consumables. Sectors like technology and telecommunication are known to perform well during a bull market. The energy sector is known to perform best at market tops and consumables and finances are at their best when the market is at the bottom.
An insight into the above gives an idea of which sectors to invest in at which stage of the cycle and thus helps in creating a strong and robust portfolio.
Needless to mention, sector rotation is imperative to obtain a higher return on investment and must be considered exhaustively before making investment decisions.