by Amanda Harvey
What is Sector Rotation Investing?
The rotation of sectors is an investment strategy which involves the movement of funds from one particular area of the economy to another, and is done with the goal of profiting from specific economic sectors as their performance rises and falls. In order to successfully implement sector rotation, a broad understanding of economic cycles as well as knowledge of the various sectors is obviously required.
Understanding Market Cycles
In all economic sectors, markets follow a basic cycle which consists of four stages. Recognizing these stages and identifying the end of one and the beginning of the next is a key for all investors.
It is generally considered that an overall trend must demonstrate growth for at least nine months before a market top can be reached. This upward movement is called a bull market cycle and nine months is actually a very conservative range, as historically, an average bull market has been 56 months in duration, but the nine months is a benchmark applied as a method to avoid overtrading. The market top is the stage of the cycle in which prices have reached as high as they are going to go, and are teetering before they begin their descent into the next stage, which is the bear market cycle. There are several indications that the bull market cycle is over and the market top has been attained, and these include a decline in the number of 52-week highs in spite of index growth, as well as the failure of prices to make higher highs, and the appearance of lower lows in the uptrend.
Following this market top, the market enters the next stage of the cycle which is the bear market cycle. When falling prices and general pessimism signal a downturn that continues for more than two months, this can be considered an entry into a bear market. When the duration has been less than two months, it may be termed a correction, rather than an actual bear market cycle. It is said that an average bear market is approximately 16 months in duration; however this average also includes short-term corrections such as the market crash in 1987. A major bear market is one that lasts an average length of four years, and usually follows about 10 years of rising prices.
The end of the bear market cycle is heralded by the arrival of the ”market bottom”. A double bottom pattern is considered to be a strong indication of a market bottom being arrived at. This occurs when a low is reached with heavy volume, followed by a bounce and then a retest of the previous low with lighter volume.
Sector Rotation Based on Market Cycles
One method of implementing the rotation of sectors as an investment strategy is to follow these economic cycle stages, seeking to enter sectors that are moving upward, and to exit these sectors when they have reached their peak.
Other Methods for Sector Rotation
Another strategy for sector rotation is a strategy based on the calendar. There are certain sectors that historically perform well at certain times of the year, and investing accordingly can be a sound method of applying sector rotation.
Investing in the rotation of sectors can also be based on a geographical component, as sectors in certain locations are influenced by various economic factors within those locations – such as in the situation where a local economy that is growing faster than the average global economy may offer opportunities for an investor to join a trend that is taking place.
A Word of Warning
When trading within the realm of sector rotation, it is advisable to keep a level of diversification within one’s investments. Avoid an over-concentration only in one sector, to minimize the risk if that sector should not perform according to expectations.
Sector rotation is an investment strategy that seeks to benefit from the natural cycles that take place within different sectors, based on economic patterns, seasonal influences, and geographical factors. By understanding these components, investors may plan effective approaches which work with the continuous change and movement that is so much a part of the financial markets and the industries they represent.