Sector Rotation – Explained in Detail

Asset classes

Sector rotation is a very key concept in stock trading. It empowers you to plan your moves given the fact that every sector faces good as well as bad times. 

So, what does sector rotation mean? Why do stock traders consider it a very valuable phenomenon? How do they use it to make a profit? These are some vital questions. Do you want to know all about sector rotation and how can you capitalize on it? Then you are on the right platform. In this article, we are going to explain sector rotation in detail. So don’t go away because you are going to learn a lot.

Sector rotation explained

Have you ever thought about the fact that the sun sets in one part of the world and rises in another simultaneously? Let me tell you how. Let’s suppose you are in the USA and the sun is about to set. You should understand that the sun is setting here and it must be rising in other parts of the world. In fact, the sun rises from the east and completes a cycle to the west. This solar cycle is the best metaphor to understand sector rotation. 

In simple words, a good time is a sun and it continues to travel from one sector to another. That means, the rise of stocks in one industry or sector never remains forever. The rise will move on to the next sector and then the next. In fact, the rise of one sector is often at the expense of the downfall of another sector. So what exactly happens? When investors feel that a correction is over the horizon, they sell stocks and move to the next sector.

What triggers sector rotation? 

As you know, economical conditions never remain the same. Conversely, the economy expands and contracts. As a result of these economical changes, the financial performance of the companies is also affected. It is a simple concept that a positive outlook on the economy leads to better performance of various companies. So, such companies attract investors. Conversely, a negative outlook on the economy leads to the worrying performance of companies. So, investors sell stocks of such companies and invest in companies with better performance. In short, this rotation of investors from one sector to another is sector rotation. 

Moreover, if we go into detail, there are three economic cycles an economy completes. You need to remember that sector rotation occurs at each cycle. The following are those cycles;

  1. The market cycle is the first. It leads the economic cycle because investors anticipate the future and make decisions accordingly. This cycle is completed in four stages – market bottom, bull market, market top, and a bear market. Thus, investors rotate sectors along the way.
  2. The economic cycle is the second. Infrequent release of economic data leading to price estimates of investors makes the economic cycle stay behind the market cycle. Full recession, early expansion, late expansion, and early recession are four stages of this cycle. 
  3. The overbought/oversold cycle is the third. This cycle enables investors to make investment decisions with precision. Again, this cycle also leads to sector rotation since investors move away from overbought stocks and move to oversold stocks. 

Sector rotation tips

It is of paramount importance to understand that the sector rotation process isn’t a straightforward one. In fact, it is very rarely clear as no one can understand how investors’ perception changes regarding different industry sectors. For example, investors tend to shift towards utility stocks as they are safer and more reliable whenever they feel that the market may correct itself. This is a very common sector rotation. However, it isn’t mandatory that investors will shift to the utility sector. 

That said, if you want to capitalize on sector rotation, active management is of paramount importance. It involves constant analysis of the market and economic cycle to recognize good opportunities. This isn’t easy though because markets often don’t incorporate economic news efficiently. Similarly, the economic cycle also struggles to catch up with the market cycle. 

Secondly, it is also important to note that industries within a broader sector may also respond differently to economic factors. For instance, increasing oil prices may affect airlines adversely but may not do the same to the railroad industry. Therefore, thorough top-down research is of paramount importance for sector rotation. 

Finally, you also need to understand the simple fact that past performance doesn’t necessarily indicate future performance with accuracy. For example, the past performance of a stock may indicate a decline after reaching the top. However, the market and economic conditions may push prices of that stock further up instead of a decline. Therefore, it is important to choose a broader approach before sector rotation. 

The wrap-up

Sector rotation is a key concept in stock trading and investing. It refers to the shift of investors from one sector to another. Investors tend to turn their attention toward rising stocks and get out of their positions in stocks already at their peak. Sectors and industries perform badly or well according to certain factors. Investors study those factors and act accordingly to make gains.

However, sector rotation isn’t an easy process. You have to consider various factors. Proper management, a top-down research approach, and a broader outlook on the economy is the key to success. 

Russell Crane

Russell Crane

Russell is an Algorithmic & Technical Analyst Trader @ PatternsWizard.
His passion is to share his knowledge about TA, patterns & more. Why hope for your trading to work when you can precisely know the performance stat of every pattern?

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