Sector rotation targets individual sectors, where sector rotators pick stocks that reflect the economic and political outlook for markets. But there are risks when timing is off or those outlooks change.
Sector Rotation in Equities
Sector rotators are investors that believe in large part the stock market reflects economic and political trends.
They use “macro” or “big picture” analysis to establish the economic and political outlook for the markets.
For example, they would focus on financial sector stocks coming out of a recession, hoping that monetary policy loosening and falling inflation would lead to lower interest rates, which in turn would benefit financial stocks. Later in the sector rotation cycle they would focus on cyclical and commodity stocks, expecting increasing economic activity would lead to higher prices for commodity stocks.
Sector rotators trade actively, moving into “out-of-favour” industries and sectors. They might own all the stocks in an industry, expecting them all to do well with an increase in their commodity price.
Timing is Everything
The potential downside of targeting a sector to significantly overweight or in the extreme case, own all stocks in the same industry is that these stocks will tend to be highly correlated in most industries. This can lead to large declines across a portfolio if the move into the sector is not properly timed or the economic or political trends suddenly change. On the other side, proper timing of a trend can be very profitable with a consolidated position across a sector. A stock picker would argue that instead of persistent sector rotation, investors would be better off concentrating on the absolute best individual stocks within those sectors to truly outperform.