However, unpredictable events are inevitable in the financial markets, which at times negate such analyses. For instance, nobody could have predicted the pandemic in 2020, and the immense market volatility that ensued. In December 2019, Wall Street forecasters had said that the S&P 500 would rise 2.7% in 2020. JPMorgan analysts made bullish stock market predictions, forecasting “mid-to-high-single-digit returns for stocks,” with little chance of extreme price swings. Both JP Morgan and Citigroup had claimed that value stocks would outperform growth stocks in 2020.
Of course, now we know that none of these predictions panned out in 2020. In fact, the stock market generated much higher returns that 2.7% and growth stocks outperformed value stocks. What is established here is that unprecedented events can lead to unexpected market trends. This is why investors often consider sector rotation analysis to predict which stocks might rise or fall, according to the prevailing economic cycle. This is because economic cycles have been predictable and consistent since 1854.
Sector Rotation Strategy
As economies expand and contract, the financial performance of companies across various sectors fluctuates. Traders try to anticipate the forthcoming economic cycle and align their portfolio allocation strategies accordingly. If the economic outlook is positive, investors buy stocks of economically sensitive companies. If the outlook turns towards the negative, they might sell these stocks and instead buy stocks of companies that are resilient to economic downturns. This strategy for stock market predictions is known as sector rotation.
Sector rotations occur in each stage of the economic cycle.
The most common cycles followed by traders are:
- Changes in the economic cycle
- Changes in the market cycle
- Transition from oversold to overbought market conditions and vice versa.
Since traders make decisions in anticipation of future price movements, the market cycles move ahead of the economic cycle.
Market Cycles and Sectors That Thrive in Each One
The stock markets move in anticipation of market cycles. So, based on the current market cycle, traders can predict stocks of which sector would soon rise.
1. Market Bottom
A long-term low point is reached due to systemic risk, against the backdrop of an economic downturn. Here, traders might try to shift towards more economically sensitive sectors like:
- Consumer Staple
- Health care
- Communication services
For example, amid the pandemic-led carnage in the financial markets, stocks like Amazon were higher by 49% (technology and consumer staple), Nvidia (technology) was up 62%, and Moderna (healthcare) gained 228.3% by July 2020.
2. Bull Market
Economic activity picks up slowly, after the worst is over. Stock price predictions of cyclical stocks are bullish here. Sectors that usually perform well are:
- Real Estate
- Consumer Discretionary
For example, mining, building sector and steel stocks outperformed on May 11, 2021, as economic activity continued to rebound. On the other hand, large-cap tech stocks were under pressure and the Dow Jones sank 500 points.
3. Market Top
Economic growth overheats and expectations for interest rate hikes gain ground. Investors show preference for defensive stocks, which are less sensitive to economic cycles, such as:
- Communication Services
Rising interest rates and tax-cut bill proposals by the Trump administration had led to financial services stocks outperforming in 2017. Based on that, analysts had kept earnings outlooks higher for bank stocks at 15.2% for 2018.
4. Bear Market
Economic activity slows down and the markets start drifting from highs towards lows. This is partly due to huge selling pressure. This acts as a precursor to the next market bottom. Sectors that perform well here are:
- Consumer staples
Clorox and Walmart performed spectacularly in the 2020 market crash and are some of the most touted consumer staple stocks for 2021 as well. Walmart has consistently beaten analyst expectations for the last few quarters till April 2021. With analysts predicting a bear market in 2021, due to business unfriendly policies by the Biden administration, consumer staples could be a sector to watch out for.
During both the 2008 and 2020 recessions, the trend of market cycles leading to economic cycles was observed. For instance, in 2008, the S&P 500 had reached its peak months before the US Real GDP growth had reached its top. As a result, investors predicted bear market performance and sold their stocks in anticipation.
Trading the Economic Cycle
The economic cycle lags behind the market cycle, as macroeconomic indicators are published infrequently and traders price in the market consensus beforehand.
But there are sectors that perform well in distinct economic cycles:
- Full Recession: This is characterised by falling GDP, falling interest rates and downfall in consumer sentiment. Sectors like utilities, consumer staples and healthcare can do well.
- Early Expansion: Here, consumer expectations are rising, and factory activity is increasing. Interest rates are still low but stable. Sectors like communication services, industrials, materials, technology and real-estate tend to do well.
- Late Expansion: Here inflation is rising, due to a rise in economic activity and consumer spending. Central banks tend to raise interest rates to tame the inflation. Sectors like financials, materials, energy and consumer discretionary tend to do well.
- Early Recession: High inflation and tapering interest rates mark this phase. The GDP starts to decline and consumer sentiment weakens. Healthcare, utilities, consumer staples are some sectors that tend to flourish at this time.
Why Consider the Sector Rotation Strategy?
Companies within a particular sector have similar exposure to economic variables and sensitivities. So, returns from these stocks tend to move in similar patterns.
This can make it easier to make stock price predictions and portfolio can be positioned optimally. There are a number of investment vehicles, like indices and ETFs, that help traders gain exposure to a particular sector.
Here too, this strategy will require an analysis of the overall market, such as:
- Interest rates
- Commodity and raw material prices
- Geopolitical factors
- Monetary policies
The sector rotation strategy can also enable diversification. However, there could be a risk of the portfolio underperforming due to the performance of the broader market indices. Whatever strategy is used, ensuring risk management is a must!