Sector Rotation & Business Cycles
“If you are in the right sector at the right time, you can make a lot of money real fast.”
- Peter Lynch
Beating the street is the holy grail for all traders and investors in the market. But timing the market is more challenging than anyone can imagine! When we think we are at the bottom, the market keeps on falling, and when we believe that the market is in full momentum, the fall comes. So how do we beat the street? The answer lies in tactical sector rotation. The business cycle in the economy and the closely linked cycle in the market govern the performance of sectors, and understanding them is the only key to timing the markets.
What is a business cycle?
Economic fluctuations are caused due to business cycles. Economists use the phrase "business cycle" to describe the rise and fall in economic activity.
Phases of a business cycle
A typical business cycle features a period of expansion, then a peak which leads to recession, post which is the depression phase, and then the lowest point is the trough where the markets hit rock bottom. However, the trough phase does not last forever, and then comes recovery, after which the cycle repeats itself.
What about the stock market cycle?
To gain a sense of market direction, it is a must to know stock market cycles. There are phases of a stock market cycle. The stock market and its cycles serve as a leading indicator of economic activity.
The four broad stock market cycle phases are:
Accumulative phase: This is the phase right after the market hits bottom. Investors and traders start buying more, thinking that the worst is over. Valuations are attractive, but general market sentiment is bearish.
Expansion or the Mark-up phase: The mark-up phase occurs when the markets appear stable and stock prices are in a momentum trend, establishing a higher high or higher low. Investors exhibit an exuberant level of optimism during this time.
Distribution phase: This is the bearish phase of the market when sellers take over and disrupt the upward moving momentum. The charts seem to go on a sideways trend. Investors who entered earlier begin to book profits.
Depression or the Mark-down phase: When the bearish sentiment gets stronger and prices start rapidly falling is the indication of a mark-down phase. The overall market sentiment looms with fear.
Market cycles have been significantly shortened as the central banks aggressively control the business cycles through monetary policies. The bear market in 2020 was the shortest on record.
The business cycle & stock market cycle are linked!
Because stock markets are forward-looking and reflect future earnings, stock market cycles are generally ahead of business cycles.
The gap between the stock market and business cycles presents investors with hurdles, as strong emotions at both peaks and troughs encourage people to purchase high and sell low when they should be doing the reverse.
Sector rotation is a top-down investing strategy involving moving money from one industry sector to another in anticipation of different business cycle stages to beat the market.
It is just like the tactical asset allocation strategy, but instead of asset class shifting, the money moves as per the expected performance of sectors. The prediction of Sector rotation is plausible because the economy moves in reasonably predictable cycles, and a specific set of industries dominate a given market cycle. While cyclical stocks do well when the economy grows, defensive stocks outperform riskier markets.
History of Sector Rotation
Let's look at the history of sector performance in the last 15 years. There were distinct bear markets in FY9, FY12, FY16, and FY20 when the Index gave negative returns, and the defensive sectors like FMCG, IT, Pharma, and Energy have outperformed. Similarly, cyclical actors like Metals, Autos, and Realty are the winners in the dominant bull phases.
The first quarter of FY23, which has just passed, has all characteristics of a bear market, especially if we look at the trend of sector returns. FMCG and Pharma are winning while metals, realty, and banks are melting.
Sector rotation is essentially about buying the doom and selling the hope. In the current market, where uncertainty is supreme due to the rising inflation numbers across the globe and central banks pushing the agenda of hiking rates, the sector rotation patterns give us a solid signal to pivot away from cyclical.
The uncertainty might disappear in a few months, and the push for growth and infrastructure could restart. But while the market is in a bear grip, the wise call is to follow the sector rotation strategy and invest in the defensive sectors.