All information you provide will be used by Fidelity solely for the purpose of sending the email on your behalf. The subject line of the email you send will be "Fidelity. The business cycle, which reflects the fluctuations of activity in an economy, can be a critical determinant of equity sector performance over the intermediate term. A typical business cycle features a period of economic growth, followed by a period of slowing growth, and then a contraction, or recession.
The cycle then repeats itself. Every business cycle is different in its own way, but certain patterns have tended to repeat themselves over time. Fluctuations in the business cycle are essentially distinct changes in the rate of growth in economic activity. This includes 3 key cycles—the corporate profit cycle, the credit cycle, and the inventory cycle—as well as changes in the employment situation and monetary policy.
While unforeseen macroeconomic events or shocks can sometimes disrupt a trend, changes in these key indicators have historically provided a relatively reliable guide to recognizing the different phases of an economic cycle. The performance of economically sensitive assets such as stocks tends to be the strongest during the early phase of the business cycle when growth is rising at an accelerating rate, then moderates through the other phases until returns generally decline during a recession.
In contrast, more defensive assets such as Treasury bonds typically experience the opposite pattern, enjoying their highest returns relative to stocks during a recession and their worst performance during the early-cycle phase. The US economy experienced 11 business cycles between and , with the average length of a cycle lasting a little less than 6 years. Some investors seek to profit from changes in the business cycle by using what is called a "sector rotation strategy.
The strategy calls for increasing allocations to sectors that are expected to prosper during each phase of the business cycle while under allocating to sectors or industries that are expected to underperform. The goal of this strategy is to construct a portfolio that will produce investment returns superior to that of the overall market. Prior to , real estate was included within the financials sector, but now it is classified as its own unique sector. One underlying premise of sector rotation strategies is that the investment returns of stocks from companies within the same industry tend to move in similar patterns.
That's because the prices of stocks within the same industry are often affected by similar fundamental and economic factors. This is a product of the sector classification framework itself: Companies are grouped together based on their business models and operations, which ensures companies within a sector have similar economic exposure and sensitivities.
For example, in the early s, rapid development of new technologies fueled growth within the information technology industry, and most stocks in that sector trended higher. Alternatively, most stocks in the financials sector moved sharply lower during the collapse of the subprime mortgage market and the subsequent credit crisis in — The decline of stocks in the financials sector during the financial crisis once again demonstrated how stocks in the same sector often exhibit similar performance during a particular phase of the business cycle.
To implement a sector rotation strategy, many investors deploy a "top down" approach. This involves an analysis of the overall market—including monetary policy, interest rates, commodity and input prices, and other economic factors. This can help investors assess the current economic environment and determine the current phase of the business cycle.
Key economic factors for each sector or industry can also help you create an estimate of future performance for each sector. The next step is to identify sectors or industries that may be well positioned for the current and future phases of the business cycle.
Depending on the phase of the business cycle—early, mid, late, or recession—certain sectors may be expected to outperform others. While each business cycle is unique, in the past certain sectors have tended to perform well at different phases of the business cycle see chart below. A sector-based strategy can be used to construct a portfolio in a variety of ways, and there are a number of vehicles that can help accomplish this objective. In the past, in order to gain exposure to an entire sector or industry, you would have had to buy the stocks of many companies.
The amount of capital required to accomplish this would be quite significant, and the commission expenses would also be high. Today, you can invest in sector-based mutual funds or exchange-traded funds ETFs to gain exposure to entire segments of the market. These vehicles enable you to gain the desired sector allocations without having to invest large amounts of capital.
They also allow you to more easily execute a sector rotation strategy and tactically adjust your equity portfolios in order to increase exposures to sectors you feel have the best return potential. While the stage of the economic cycle is a common reason guiding many sector rotation strategies, investors often look for other reasons as well.
For example, many investors rotated into technology stocks during the early period of the Covid pandemic because the products and services these companies provide were vital to a broad shift to remote work. Outside of moments of clear pending economic crisis, investors may look to legislation that targets specific industries when deciding which sectors they may want to invest in. To enact a sector rotation strategy, you can invest in individual stocks or mutual funds and exchange-traded funds ETFs that target segments of the economy and make it easy to gain diversified exposure to particular sectors.
If you like the idea of sector rotation, but are skeptical of the amount of work such a strategy would entail, you can also opt for actively managed mutual funds or ETFs that employ sector rotation strategies. Keep in mind that these kinds of funds often charge much higher fees than it would cost you to enact the same strategy yourself, and active management styles, like sector rotation, have historically trailed simply buying a broad market index fund and holding onto it long term.
Active investing, such as deploying a sector rotation strategy, inherently adds some risk—along with potentially higher returns—to your portfolio. Sector rotation strategies also increase volatility because your portfolio will be more and less exposed to various sectors compared with a buy-and-hold strategy that tracks the broader stock market.
Using mutual funds and ETFs, sector rotation can be a relatively easy way for the average investor to take a more tactical approach to investing and potentially capture higher returns. This strategy can be used in combination with the portfolio rebalancing you may already be doing to make sure you maintain your desired level of investing risk. It also may increase the overall risk and volatility in your portfolio, and it could introduce transaction costs and taxes you might otherwise avoid.
While the goal of executing sector rotation is to achieve higher returns than the overall market, the risk of mistiming your rotation decisions could mean that you end up underperforming broad market benchmarks. John Schmidt is the Assistant Assigning Editor for investing and retirement. Before joining Forbes Advisor, John was a senior writer at Acorns and editor at market research group Corporate Insight.
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What Is Sector Rotation? How Does Sector Rotation Work? Sector Rotation Strategies Sector rotation strategies can be as simple or as complex as investors make them. Cyclical stocks. Cyclical sectors include companies where consumers make discretionary spending like retailers and restaurants or technology providers. These sectors historically outperform the market when the economy is expanding and consumers and businesses have greater demand for related products or services.
Defensive or non-cyclical stocks. Companies in these sectors tend to have steady demand, even during periods of economic weakness, because they offer necessary products or services. Examples include utilities, healthcare and consumer staples like food producers or distributors. How to Use Sector Rotation in Your Portfolio To enact a sector rotation strategy, you can invest in individual stocks or mutual funds and exchange-traded funds ETFs that target segments of the economy and make it easy to gain diversified exposure to particular sectors.
Sector Rotation Risks Active investing, such as deploying a sector rotation strategy, inherently adds some risk—along with potentially higher returns—to your portfolio. Was this article helpful? Share your feedback. Send feedback to the editorial team. Rate this Article.
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What Is Sector Rotation? Sector rotation is. When a sector reaches the peak of its move as defined by the economic cycle, investors should sell that ETF sector. Using. Sector rotation involves active management, which requires frequent monitoring of market and economic events in order to capture opportunities.