Advanced Investing & Portfolio Management

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Sector Rotation

LESSON 2

In this section, we will introduce you to lagging economic indicators and we will dive into arguably the most important one: GDP.
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Now that we know what sectors and industries are and how they can behave differently in certain economic conditions, let’s examine a great portfolio strategy that many investors use to benefit from sector fluctuations.

Sector Rotation Investment Strategy

Many investors use the concept of sector rotation to think about the relationship between industry analysis and the business cycle when it comes to investing and overall portfolio allocation. The idea is to shift the portfolio more heavily into industry or sector groups that are expected to outperform based on your assessment of the state of the economy. In other words, position your investments to fit what you think is going on in the economy. E.g. if you think economic growth may slow down, invest in safer assets, etc.

Business Cycles

We have seen how the economy works, so we have an idea of what economic (or business) cycles are: fluctuations in the economic activity over time. Below is a depiction of a simplified business cycle:

 

We will continue to analyze what could be some good choices at each point of the business cycle. The following are some ideas that have proven to work in the past, however, we do not recommend taking these to heart as they are simply ideas to take into account.

  • Near the peak of the business cycle: near the peak of the business cycle, the economy might be overheated with high inflation and interest rates and price pressures on basic commodities. At this point, it may be a good idea to invest in firms engaged in natural resource excavation and processing such as minerals and petroleum. 
  • Following the peak of the business cycle: when the economy is getting into a recession (or contraction), it may be best to shift your portfolio to defensive industries that are less sensitive to economic conditions, for example, food, pharmaceuticals, an other necessities. These have proven to perform better than other cyclical industries.
  • At the height of the contraction: financial firms will be hurt by shrinking loan volumes and higher default rates and discretionary good may be hurt by a decrease in household incomes. However, staples may not be as hurt by the downturn.
  • Toward the end of the recession: at this point, inflation and interest rates tend to be lower, which favors the financial sector.
  • At the trough: the economy is bound to recover and a subsequent expansion is feasible. Then, businesses may get back to spending on new equipment to meet anticipated demand increases, which means it’d be a good moment to invest capital good businesses, such as machinery, construction and equipment.
  • In the expansion: when incomes and spending starts rising again it may be a good idea to shift over to discretionary, cyclical industries such as luxury items, which have proven to be very profitable in this stage. Banks and financials may also perform well as loan volumes recover and default risks decrease again.

As we can see, when investor confidence in the markets is low, investors tend to shift into noncyclical industries like staples or healthcare. And when investors expect an expansion, they tend to look for opportunities in cyclical industries like technology or industrials.

It is crucial to keep in mind that this investment strategy aims to time the economy and the markets, which is extremely difficult. In addition, it will only truly work if you are able to time the markets better than other investors; otherwise, you may be too late to the party, prices may have shifted before you could do anything.

In reality, it is never clear how long each stage is or when the next one is coming. Also, the markets are influenced my so many factors that can affect the business cycle  and speed it up, slow it down, change its course, or completely break it. Therefore, this strategy requires a high level of knowledge and overall risk tolerance. However, it can be used to make minor adjustments to your portfolio without running into too much extra risk. For instance, if you believe that the next market crash may be coming soon, it could be good to slowly shift your portfolio accordingly.

In the next section, we will discover the typical stages of an industry’s or a company’s life, called the Industry Life Cycle.

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