Sector Rotation Strategy

Business Cycle Investing

Sector rotation is another form of tactical asset allocation and should be used to manage investment portfolios that use strategic asset allocation as a base. The concept of sector rotation investing is based on the premise that certain sectors and industries are more dependent on the evolution of the business cycle, which leads some companies to perform better than others during certain phases of the business cycle.

There are typically four different phases of the business cycle each of which can be loosely defined and whose transition from one phase to another is subjective and certainly not definitive. They may be called by different names but are generally referred to as Early Stage/Recovery, Mid-Cycle/Expansion, Maturity/Late-Cycle, and Recession/Contraction. The chart below provides a different set of names for each phase, namely, Full Recession, Early Recovery, Full Recovery, and Early Recession.

Sector Rotation Chart - stockcharts

Despite the difficulty identifying the exact point in the business cycle, we can still identify trends within the business cycle that enable us to determine when certain sectors or industries are poised to excel while other sectors are reaching their peak. Our ability to shift our portfolios to those companies expected to outperform during each phase of the business cycle is yet another way that investors can add a few percentage points to the returns they achieve in their portfolios.

The different business cycle phases

Early Stage/Recovery

In the early stages of the business cycle, economic indicators have stabilized from what could have been a shallow or deep contraction. There are numerous data points that economists analyze to try to determine the end of a recession and the beginning of a recovery. On very few occasions, all of the metrics will be trending in the same direction and there are even fewer occasions that result in trends moving in a linear fashion. More often than not, data points for such metrics as GDP, PMI, Unemployment rate, and a variety of others, do not improve in a straight line but can be relatively volatile whether in an upward or downward trend. This is why determining the phase of the business cycle is more of an art than a science and trying to time the exact point to adjust portfolios is impossible. The best we can hope for is a gradual adjusting of our portfolios to try to capture the shifts in the business cycle and the outperformance of companies in those sectors expected to outperform.

The early stage/recovery phase follows a recessionary period and typically occurs when declining economic indicators begin to stabilize and may start reversing their trend. Within any phase of the business cycle, the level of conviction you have that the next phase is approaching should be directly linked to the number of indicators that confirm it. If only a couple of indicators seem to be stabilizing and improving, it is difficult to determine if the economy has truly entered a new phase or the data improvement was coincidental. If there are many positive indicators then you can be more certain of an imminent recovery.

The early stage phase is typically associated with high levels of sales growth, low inventories, and accommodative monetary policies. The early cycle usually benefits companies in the Consumer Discretionary, Materials, Industrials, Financial and Technology sectors, where those sectors tend to outperform the broader index by anywhere from 5% to 10% annualized.

Early Cycle


When economic indicators become positive and begin to improve at a more moderate rate, this is usually an indication of the expansion phase or Mid-cycle. In this phase, companies are growing sales and profits, the labor market is improving, and the consumer is confident and spending. In this phase, companies are spending capital on building new plants, developing new products, expanding operations, investing in technology, and hiring more resources. It becomes a virtuous cycle whereby the economic engine feeds itself and builds momentum.

Mid-cycle tends to benefit companies in the Technology, Energy, Industrials, and Healthcare sectors, but notice that the outperformance of these sectors is in a much narrower range than in the early cycle phase shown above.

Mid Cycle


As the economy continues to grow, it eventually starts to slow down as inflation begins to rise, inventory levels increase and sales decline. Credit also becomes tighter, making it more difficult for consumers to finance purchases and for companies to issue debt for capital expenditures.

In the maturity phase or Late Cycle, companies that benefit include those in Energy, Materials, Healthcare, Staples, and Utilities. In this phase, defensive sectors begin to perform well in anticipation of slower economic growth and risks of recession. Also note that the relative outperformance of sectors we mentioned above returns to the 5%-15% range.

Late Cycle


A recession is accompanied by restrictive monetary policy designed to reduce inflation, very slow growth or contraction in economic output, a rise in unemployment, and inventory declines despite slower sales growth, which results in lower corporate production.

During a recession, defensive sectors tend to outperform cyclicals and include Consumer Staples, Utilities, Telecom, and Healthcare. By no means should this mean to suggest that these sectors will have positive performance during a recession, only that they tend to outperform other sectors during an economic contraction. The chart below indicates that while the overall equity market average was -13.9%, the better performing sectors only outperformed by 6% to 15%, indicating that even the best performing sectors probably had negative returns.


Sectors Summary

The following tables summarizes some of the characteristics of the companies in each sector. Each sector is represented by its corresponding SPDR Select ETF, whose tickers are shown on the second row. (Note that Telecom is not included in the table below because it is included within the technology sector.)

Utilities usually pay the highest dividend yields of all the sectors but interestingly, the technology sector pays the second highest dividend yield of 3.1%. While this may not make intuitive sense at first, consider that many technology companies awash with cash have implemented dividend paying policies to return some of that cash to shareholders.

By comparing the standard deviation of each sector we can also compare the volatility, or risk of each sector relative to other sectors. Consumer Staples, Healthcare, and Utilities have the lowest standard deviation and coincidentally, these sectors are considered defensive. Morningstar also provides an overall risk score, labeled MS Overall Risk. In each Morningstar Category, the 10% of funds with the lowest measured risk are described as Low Risk, the next 22.5% Below Average, the middle 35% Average, the next 22.5% Above Average, and the top 10% High. Morningstar Risk is measured for up to three time periods (three, five, and 10 years). These separate measures are then weighted and averaged to produce an overall measure for the fund. Funds with less than three years of performance history are not rated. Morningstar also places more emphasis on downside risk than a traditional standard deviation measure.

Sector Summary2

Implementation of Sector Rotation Strategy

To implement a sector rotation strategy, there should be a robust underlying asset allocation strategy for the portfolio. A common rule of thumb is to determine the equity allocation for the portfolio and to assign a neutral weighting to each sector. A neutral weighting to each sector should be indicative of the overall market. For example, if setting the asset allocation for US Equity exposure, you might use the S&P 500 as a benchmark, and make an allocation to each sector in direct proportion of each sector’s allocation within the S&P 500.

Having the asset allocation as a starting point, you can then determine what phase of the business cycle we are currently in and over/underweight each sector as appropriate. As the business cycle evolves, you can then shift assets away from sectors expected to underperform in the next phase of the business cycle and into sectors expected to outperform.

The most opportune moment to implement such shifts are extremely difficult to time so the best approach is to make gradual changes to your portfolio as the next phase of the business cycle approaches. Don’t worry too much about timing your adjustments perfectly because even professionals find this to be challenging.

For more experienced investors, there is also the possibility of rotating within sectors from industry to industry as the business cycle evolves. For example, within the Industrials sector, transportation companies, such as railroads, may be first to benefit during the expansion phase because transportation companies move raw materials to manufacturers that produce the final goods for consumption. The manufacturers would be next to benefit as these raw materials are applied to making finished goods.

Keep in mind also that sector rotation in the US may differ greatly from a sector rotation strategy in other countries or regions. For example, natural resources are a big portion of the market cap of Brazil, so not only does this affect the ‘neutral’ allocation of the portfolio, but because natural resources dominate such a large part of the economy of the country, sector allocation to other sectors may not be possible because other sectors may not be well developed enough.

A summary of how sectors perform during economic cycles is shown below.

Sector Graph

Last Words

When looking to make sector allocation changes to your portfolio, make sure you do them gradually and ensure that you have a good understanding of where we are in the business cycle. That doesn’t mean you need to be able to pinpoint an exact point in the business cycle but knowing the transition signs is a good way to gauge your allocation timing without trying to ‘time the market”. In the long-run, with proper portfolio management, you may be able to slightly outperform a more rigid asset allocation strategy.

Sources: Morningstar, Fidelity