The pitfalls of a sector rotation strategy

Portfolio management

It sounds like such a clever idea

So many professional money managers say they practice sector rotation through the business cycle, I feel it is a subject that should be looked at in more detail. I suspect that a lot of ETF investors also practice the same strategy.

It’s fraught with difficulties.

A timing strategy by any other name

Sector rotation through the business cycle is a timing strategy. Since most investors get timing wrong, I am not advocating this as a strategy. What I do advocate and what I do follow myself is using knowledge of the likely impact of the business cycle on different sectors to inform the decision to buy any particular stock with a substantial margin of safety. The strategy then becomes buying by way of price rather than by way of timing. On this critical distinction please see my post: The cornerstone of investment success

I very much suspect this approach cannot be used by ETF investors as it requires an assessment of the fair value of the companies that are included in the ETF.

As for investors in individual stocks, the simple fact is that few have the expertise to identify not only where we are in the business cycle but also know how the cycle will unfold. The former involves a sophisticated knowledge of economics and the latter the ability to forecast where the economy is going.

Not only is such forecasting virtually impossible, but there is often no correlation between the economy and the stock market. Investing based essentially on the business cycle outlook is a fools’ game.

Of greater importance is the fact that the stock market and the economy very often do not march to the same drummer. They are often out of step. So, trying to pursue stock market timing based on one’s outlook for the economy is not a good idea.

So what is sector rotation investing?

The writer has read many analyses of how to adopt the business cycle to sector investing. What follows is an explanation of sector rotation from RBC Direct Investing, a unit of the Royal Bank of Canada. I offer this explanation so investors will know what not to do, rather than to help them do it.

“Business Cycles

Early recession – The economy begins to slow and consumer expectations are at their worst; industrial production is falling sharply, interest rates are at their highest, and the yield curve is flat or even inverted. Historically, the following sectors have profited during these times:

• Consumer staples (near the beginning)

• Health care

• Utilities (midway)

Recession – When the economy is down, industrial production is at its lowest point, people are losing jobs, interest rates begin to fall, and the yield curve is normal. Although consumer expectations are low, they are beginning to improve. The sectors that have historically performed well in this stage include:

• Consumer discretionary (near the beginning)

• Financials

• Information technology (near the end)

Early recovery – When the economy begins to improve and consumer expectations are rising, industrial production begins to grow, interest rates have bottomed and the yield curve is either normal or has begun to steepen, the sectors to consider investing in at this stage include:

• Financials (near the beginning)

• Transportation (near the beginning)

• Industrials

• Energy (near the end)

Late/full recovery – At this point in the business cycle, interest rates are usually rising rapidly and the yield curve has flattened. Industrial production is slowing and consumer expectations are beginning to fall. Historically, the most profitable sectors in this stage have included:

• Energy (near the beginning)

• Materials

• Precious metals “

Chart source: RBC Direct Investing.

I have referenced this analysis not because investors should practice business cycle sector rotation but because investors should understand what a large number of other investors are up to.

The simple message from this is that we must by all means educate ourselves as investors about the business cycle and its relationship to the different sectors. This education will inform us as we invest using the sound principles of operation we have committed to follow.

But, don’t try to follow a strategy of sector rotation through the business cycle. It really is not possible.

To read further on how to put a portfolio together see generally Chapter 36. Diversification, balance and strategy

That Chapter contains various sections as follows:

36.01 Correlation

36.02 Digression to idiosyncratic risks and unexpectables

36.03 Correlation continued

36.04 Balance and hedging

36.05 Balance between sectors

36.06 An aside on industrial commodities and agriculture

36.07 Correlation and the business cycle

36.08 A sector rotation strategy

36.09 Company size