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Strategic Market Analysis: Interpreting Sector Rotation

Key to successful sector investing is the ability to detect emerging trends in sector rotation, and either the subsequent trend reversal or else alternative sectors offering better return potential; MarketScalpel's visual Sector Heatpmap Tool  is specifically designed to facilitate this.

Defining and Measuring Sector Rotation

We use the term 'sector rotation' in the broadest sense to refer to material investor flows in and out of sectors, that represent the building blocks of trend. The preferred metric for measuring this is price movement, but our proprietary volume confirmation rankings - based on our sector Money-Flow and breadth data - can also provide significant intelligence especially regarding the degree of conviction underpinning leadership.

However, we do not endorse what we refer to as the conventional view of sector rotation, which posits that a reliable and therefore foreseeable progression of shifts in sector preferences occurs through the business cycle.

Sector Rotation Through the Business Cycle - The Conventional View

The conventional view of sector rotation was perhaps first comprehensively articulated by Sam Stovall in the S&P strategist's 1996 book "Sector Investing"

It represents the belief that investing in certain sectors at different stages of the business cycle can deliver superior semi-automatic returns relative to a purely passive strategy.  The preferred sectors through the various stages of the business cycle are laid out for reference in graphic and table form.

The purported progression in sector preferences through the economic cycle is quite elegant supported by well thought out industrial logic, but unfortunately it does not appear to correspond with reality. 

Firstly long-term outright leadership at the subsector and industry group levels tends to be surprisingly persistent, frequently evident for periods longer than multiple business cycles rather then divisions thereof.  Secondly our work analyzing intermediate broad market declines shows that selling pressure typically rotates 360 degrees around sectors completing in much shorter periods than suggested by the conventional sector rotation view, with few groups if any ultimately left unscathed. 

Even so patterns of shifting sector rotation resulting in upside and downside market leadership can certainly be discerned within both broad market advances and declines.  However, experience suggests these rarely exhibit more than superficial resemblance to the no doubt soundly based industrial logic theorized to exist by conventional sector rotationists

A Formal Critique of the Conventional Sector Rotation View

In a 2007paper professors Stangl, Jacobsen and Visaltanachoti tested a conventional sector rotation strategy investing in prescribed sectors through the course of the business cycle using almost 60 years' data.   

They found this delivers only a 2 percent alpha allowing for timing business-cycle stages with perfect hindsight (using NBER dates) and ignoring any transaction and market impact costs. Adjusted for real world conditions, including the vagaries of forecasting the economic cycle and slippage, these returns are at best marginal and offer a poor Sharpe ratio relative to a passive strategy. 

Deciphering Market & Economic Intelligence

In spite of the marginal excess returns delivered by the conventional sector rotation strategy, there are nevertheless compelling grounds for active market participants to stay abreast of themes suggested by the model.

For example, our top down market-by-sector visual analysis tools rapidly revealed that consumer non-cyclical sectors and parts of Healthcare were relatively strong from the middle of the 3rd quarter of 2007, in the face of otherwise broad-based weakness.  These areas were nevertheless not immune from the early January downdraft but this intelligence nevertheless served to caution that a defensive stance was being adopted.

In other words whereas the evidence for the ability of the conventional sector rotation model to deliver excess returns is flimsy, it can provide valuable information regarding the market's assessment of the economic outlook.  As such the chances of correctly determining the stage of the business cycle can be significantly improved, allowing for timely changes in investment strategy and/or asset allocation when the fundamental outlook changes.

Enabling Dynamic Sector Allocation

We believe there is no readymade sector rotation roadmap that delivers automatic investment outperformance.

However, our Market Navigator sector research platform offers superior tools for identifying sectors where rotation offers the best potential to capture returns regardless of the stage of the business cycle.


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