How to Invest Using Sector Rotation

The U.S. economy moves in different stages.

There are periods when it either grows or shrinks, and these changes can influence how people invest.

The economy expands when there is an increase in employment, consumer spending and real gross domestic product, or GDP. This is also known as an economic recovery.

An economy contracts when activity slows down or when there’s a decrease in real GDP. In this stage, the economy may experience lower employment and reduced consumer spending.

These economic fluctuations affect the performance of different stock market sectors. During changes in economic cycles, investors should hold stakes in companies that will outperform the overall market and step away from others that may underperform.

If you’re interested in playing a sector rotation strategy, here’s what you need to consider:

— What is sector rotation?

— Strategies for sector rotation.

— The risks of sector investing.

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What Is Sector Rotation?

The stock market has 11 different sectors, according to the Global Industry Classification Standard. These include consumer discretionary, financials, real estate and information technology, among others.

These sectors perform differently depending on the phase of the economy. While some sectors may be more receptive to economic growth, others may underperform.

“Sector rotation is the process of selling out of sectors when the economic cycle suggests that their sector may not perform well, and then allocating those investable assets into sectors that are likely to perform better on a relative basis when that economic cycle suggests it,” says Wade Guenther, partner at Wilshire Phoenix in New York.

In the early stages of growth, when the economic cycle is moving away from a recession and into a recovery phase, economic activity bounces back and company profits increase. Sector leaders during this stage include consumer discretionary since people have more money to spend. Financials could also benefit from an expanding economy since interest rates tend to be supportive for banks and other businesses.

During late stages of the economic cycle, investors tend to rotate out of sectors such as consumer discretionary or information technology because some experts say future growth forecasts may be lower than they would be in earlier stages of the economic cycle.

When the economy is performing poorly or enters a recessionary stage, look to defensive sectors such as consumer staples that fall into the categories of grocery stores, pharmacies and companies whose products are used daily regardless of economic conditions. Other defensive sectors, such as health care and utilities, tend to perform well because people still need products like food, groceries and other daily essentials, even in a downturn.

“Health care companies tend to have similar earnings growth patterns across all economic cycles (and have) often outperformed many technology economies in declining or recessionary economic cycles because those revenue streams have been more predictable,” Guenther says.

Revenue and earnings from utility companies are also consistent through different economic cycles.

Even though the stock market is not the economy and these dynamics are not always at play, given historical performance, this is how the market tends to function over time.

[See: 7 Preferred Stock ETFs to Buy Now.]

Sector Rotation Strategies

Having a diversified portfolio with investments in a variety of different sectors is a basic investment strategy. That said, investors may want to consider sector rotation strategies to take advantage of any potential growth opportunities that could arise during changes in economic cycles.

Experts say the preferred method of sector rotation investing is through exchange-traded funds, or ETFs. These funds have favorable characteristics that make it simple to flow through different sectors given their liquidity, low costs and low barriers of entry.

Guenther says iShares and SPDR cover all 11 sectors and do a great job in indexing each of the sectors.

“Investors have the opportunity to invest in each specific sector of the S&P 500 through a single investment,” he says.

When the economic cycle changes, investors should allocate their assets across different sectors. Asset allocation is one of the fundamental factors you need to consider when sector investing. Mike Loukas, principal and CEO of TrueMark Investments, recommends a standard asset allocation and exposure to many sectors.

“In the case of a rotation, you can adjust the weightings in those sectors, but you shouldn’t be moving from 100% to zero and then moving it over to another sleeve — that’s tactical management, which is really hard to do, even for professionals,” he says.

The best way to play a sector rotation, Loukas says, is to focus on asset allocation and maintaining diversification while tilting those asset allocations toward whichever rotation is at play.

With this approach, you may not precisely enter or exit a rotation at the perfect time, but you can still capture some of the market rotation while managing your risks.

Loukas says it’s important for investors to realize that, in any sector, there are winners and losers even if a particular sector is in favor or not. That said, investors may want to take an active management investment approach at an individual stock level because sector rotation may not apply to every name in a particular sector.

“In this type of sector rotation, it’s a great opportunity to pursue some active management within that sector because you have the ability to weed out the inferior companies and own the fundamentally strong companies,” he says.

[READ: Gold Versus Bitcoin: Which Is the Better Investment for You?]

Sector Investing Risks

Buying and selling stocks using a sector rotation strategy can be a tricky task, so every investor needs to consider the risks when moving in and out of different sectors.

The goal of successful sector investing is to buy stocks that are poised to outperform the market. Investing between individual sector stocks can be a challenging way to manage your portfolio because if the sector rotation doesn’t end up working in your favor, single-stock risk is a reality.

“There could be the risk that the stock you are trading out of performs better than the stocks you are trading into,” Guenther says. So it’s important to understand what you’re buying at the stock and sector level.

Market timing is another risk. The timing of sector rotation can be difficult to pinpoint for investors.

An easy solution to market timing risk is to simply stick to a long-term investment plan.

“Construct a portfolio that allows you to benefit from different themes or trends in the marketplace but doesn’t expose you to all the risks,” Loukas says.

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