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Business News/ Money / Personal Finance/  What is sector rotation and how does it work?

What is sector rotation and how does it work?

Sector rotation is the strategy employed by investors to shift their investments between different market sectors based on changing economic conditions and the anticipated performance of those sectors in specific stages of the economic cycle.

The stock market cycle is always a few months ahead of the economic cycle.Premium
The stock market cycle is always a few months ahead of the economic cycle.

Think of what you eat more of during the summer. Perhaps mangoes, watermelon, cucumber, mint, and fresh juices? Quite different from what you consume more of during the winter and monsoon, right? Just like your diet and nutrition sources change as the seasons change, your investment portfolio also needs an occasional rebalance so that it can make the most of changing economic conditions and trends.

The economy moves in a reasonably predictable cycle, known as the economic cycle, across four phases — expansion, peak, contraction, and trough. Several industries and companies are impacted by the phase the economy is in, and that’s where sector rotation comes in.

And, regardless of which online trading and investment app you use, you too can benefit from sector rotation once you’ve understood the principles behind it. So let’s take a closer look at it.

What is sector rotation?

Sector rotation is the movement of investors’ funds from one stock market sector to another in order to make the most of changing economic conditions and optimise returns. Savvy investors tend to anticipate the next stage of the economic cycle, and at a certain point they sell their holdings in a certain sector and use the funds thus released to invest in a different sector that tends to perform well in that specific stage of the economic cycle. This constant rotation in and out of different sectors to capitalise on the pace and direction of economic growth is called sector rotation.

It’s important to note that the stock market doesn’t move with the economic cycle at the same time. That’s because investors are always looking ahead, and their decisions are based on the anticipation of the next stage of the economic cycle. Hence, the stock market cycle is always a few months ahead of the economic cycle.

How does sector rotation work?

Due to reports by governments and economists, every economic cycle’s approximate start, duration, and end has been known since the 19th century. And, which industries tend to perform well during different economic cycles is also known fairly well. Hence, at this point, one of the most common ways that investors carry out sector rotation is by moving their money between two stock categories — cyclical and non-cyclical stocks.

Cyclical or offensive stocks are stocks that are sensitive to changes in the economic cycle. For instance, the performance of companies in non-essential industries like automobiles and luxury goods is directly linked to the direction and pace of economic growth. Conversely, non-cyclical or defensive stocks, such as those in the utilities and healthcare sectors, are not as sensitive to the economic cycle. Such stocks tend to have a fairly stable demand both during economic booms and recessions.

One of the most popular sector rotation strategies is to rotate out of defensive stocks and into offensive stocks when the economy is expected to grow, and to do the reverse when an economic slowdown is expected.

Current and upcoming trending sectors

As of Q2 2023, while central banks around the world might stop hiking interest rates soon, inflation is expected to remain high, and a mild recession appears inevitable.

During such periods, when inflation is high, GDP growth is declining, the yield curve is inverted, and a recession might be on the horizon, there are certain sectors that have historically been rotated into. These include communication services, healthcare, utilities, and consumer staples.

Other than these sectors, dividend-paying stocks, specifically dividend-grower stocks, can be good investments during such times. It’s been historically seen that dividend-paying stocks tend to outperform non-dividend-paying stocks in periods of economic downturns and are usually less volatile. And those stocks that have a history of dividend growth tend to do better in rising interest rate environments marked by high inflation.

An important thing to note is that you also have to take into account your risk tolerance and financial goals. That’s because sector rotation is at least partly based on speculation. Hence, it’s also important to not get overly fixated on the changes in the economy and markets, and to maintain a long-term investment strategy.

How to take advantage of sector rotation?

Sector rotation requires active investment management and portfolio rebalancing, which can get complex fairly quickly. This is because it requires a significant amount of not only time but also market knowledge and expertise.

However, you can still take advantage of sector rotation without having to invest a lot of time or energy in understanding market trends and patterns. You can do this by investing in sector Exchange-Traded Funds (ETFs). Sector ETFs invest in a specific industry, and by adding them to your portfolio, you can make the process of sector rotation a lot more easy and cost-effective.

Additionally, by investing in sector ETFs of markets other than the Indian market, you can not only diversify your investment portfolio but also make the most of economic cycles in other countries.

Yogesh Kansal is Co-founder, Appreciate.

The FMCG sector is likely to reach Rs 16.3 lakh-crore by 2025.
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The FMCG sector is likely to reach Rs 16.3 lakh-crore by 2025.

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Published: 09 Sep 2023, 12:09 PM IST
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