When the sun sets in your part of the world, does it go away completely? Of course not: when the sun sets somewhere, it rises somewhere else. Just as important, wherever the sun has set, you can be assured that it will rise again at some point.
This is true in astronomy but also in the financial markets. Market rotation, also known as sector rotation, allows patient and forward-thinking investors to take advantage of the ups and downs that markets have experienced throughout history and will continue to undergo as long as human behavior remains predictable.
What Is Market Sector Rotation?
Market sector rotation involves the movement of money from one sector or part of the market to another.
It’s called “rotation” for a good reason: like the earth revolving around the sun, money will move away from one area of the market to another for a while but will inevitably (or at least, probably) return sooner or later.
Unlike the earth revolving around the sun, however, a full market rotation doesn’t occur over 24 hours. It’s a process that can take months or even years as shifts in sentiment cause investors to pull their money out of one group of financial assets and into another.
Studying rotation can help us understand how cyclical and sentiment-driven the financial markets really are. In the stock market, investors might collectively favor fast-growing technology stocks for a while; 2021 provided a prime example of this as traders bought up shares of famous tech names like Alphabet/Google and Meta Platforms.
In contrast, many of those same investors who rotated into large-cap technology stocks in 2021 rotated out of them and into defensive stocks like General Mills and Eli Lilly as markets turned down in 2022.
Sentiment shifts constantly (though not necessarily quickly). At any given moment, investors could favor or disfavor any number of market sectors: technology, consumer staples, energy, healthcare, banks, commodities, you name it.
The cycles of money movement aren’t based on what’s happening at the moment. Investors tend to be forward-looking. In other words, they’re positioning themselves for what they believe will be the next cycle, often months in advance.
Is Market Rotation the Same as Economic Expansion and Contraction?
Economic expansion and contraction can lead to market rotation, but they’re not the same thing.
When the economy is firing on all cylinders, that’s expansion. It’s marked by low unemployment, wage growth, and growing corporate earnings and gross domestic product (GDP). When those factors are moving in a negative direction, those are signs that the economy is shrinking or contracting.
Market rotation is a response to those larger economic cycles. When the economy expands, investors rotate out of more defensive sector assets, such as consumer staples and utility stocks, and possibly government bonds and gold.
Those asset classes don’t necessarily lose value, but they may underperform compared to riskier assets, such as technology stocks, that draw investment during expansionary phases.
Economic contraction induces the opposite behavior: rotation out of high-risk assets and into safety-focused investments, with cash and government bonds often being considered the safest of all (as evidenced during the COVID-19 crisis of March 2020).
Even during times of relative calm where there’s no strong tendency toward economic expansion or contraction, there can still be rotation between stock-market sectors.
Is it possible for investors to capitalize on these sentiment-driven movements?
How to Use Market Sector Rotation to Your Advantage
It is often possible to take advantage of temporary cycles in the financial markets. Having a “this, too, shall pass” attitude and knowing that rotation is usually transitory can help you stay anchored when billions of dollars flow from one sector to another.
Ultimately, capitalizing on market rotation means being a contrarian: thinking independently and moving in the opposite direction from the crowd. Contrarian investing has helped legendary investors like Warren Buffett and Charlie Munger build vast amounts of wealth over time.
Certainly, it’s easier for contrarians to take advantage of market rotation during times of strong economic contraction. After investors rotated into cash and government bonds in March 2020, you could have bought practically any sector of large-cap stocks and profited handsomely just by holding your shares throughout the remainder of 2020 and all of 2021.
Folks with the gumption and the foresight to reallocate into quality companies in risk-on sectors like technology fared particularly well during the stock market’s recovery from the COVID-19 crisis.
When the economy contracts, rotating into defensive names can help you shield your wealth against volatility. During turbulent times for the economy, relatively safe sectors like consumer staples and utilities have traditionally lost less than high-growth areas of the market.
The Contrarian Approach
A true contrarian is more likely to reallocate into defensive stocks when most investors are complacent, and stocks are generally expensive rather than waiting until the economy and financial markets encounter turbulence.
When the economy isn’t strongly trending in either direction – boom or bust – the rubber really meets the road when it comes to sector rotation. Don’t assume that money can’t be made when the overall market is going sideways, as there’s almost always some form of sector rotation going on under the hood.
Contrarians can look for segments of the economy that happen to be currently out of favor but which have a long track record of consistently making a comeback sooner or later.
It takes a strong stomach to buy large-cap bank stocks, for example, when most traders are selling their shares from that sector, but capital has always flowed back into those sectors eventually.
It also requires clear-headed, non-emotional thinking to take profits on, say, real-estate stocks when prices are high, and seemingly everyone is predicting blockbuster returns in that sector.
Remember that the goal is to buy low and sell high, which often means selling when everyone else is buying and buying when everyone else is selling.
Most investors will buy defense stocks when the sabers are rattling, and the news is all of the war and sell them when peace breaks out. The contrarian will buy them when everyone’s talking peace and sell them when the next war breaks out.
Research Is the Key to Profiting from Market Rotation
Most of all, you’ll need to keep tabs on the ups and downs of various market sectors in order to apply these contrarian principles profitably. It’s important to keep up with daily changes in overall investor sentiment while also having the patience to wait until a particular sector is heavily favored or disfavored before you hit the “buy” or “sell” button.
As always, outperforming most investors means keeping your emotions in check and using other people’s extreme or irrational sentiment shifts to your advantage. That’s the essence of capitalizing on market rotation, where cycles aren’t always predictable, but they are certainly inevitable.
The post What Is Market Rotation and How to Use It to Your Advantage? appeared first on FinMasters.
FinMasters