Most investors have heard the popular adage to sell stocks when others gets greedy and buy when others are fearful. But that advice begs the question, 'Sell what? And buy what?'
An entire theory called the 'Sector Rotation Model' identifies which types of stocks perform well during specific points of market and economic cycles. Based on Sam Stovall's S&P's Guide to Sector Rotation, the model asserts that different sectors are strongest and weakest at different points in the economic cycle. You want to rotate into stocks that are about to outperform and rotate out of stocks whose best days are behind them.
Most experts consider the stock market to be a leading indicator of the economic cycle, usually leading by at least a six months. A bullish stock market trend precedes a burgeoning economic expansion; likewise, a bear market trend predicts a coming economic contraction. The stock market's nature is to be forward-looking, discounting future dollars into today's dollars based on prevailing interest rates.
Exhibit 1: Sector Rotation Model*
The chart can be used whether you want to follow the market cycle or the economic cycle. Just remember that the stock market typically leads the economic cycle by at least 6 months. The key to sector rotation is to keep looking ahead to what is coming next, staying one step ahead of the euphoria and panics that tend to set in as investors work their way through economic and market cycles.
Economic Recovery/Market Peak
Most economists believe that today we're in the midst of an economic recovery. While that is good in a lot of ways, as an investor, note that according to sector rotation, the middle of a recovery generally coincides with the peak of the bull market. Though the economy continues to improve, the market starts looking ahead to the next recession and making downward pricing adjustments.
According to the excellent charts found at StockCharts.com, the consumer discretionary and industrial sectors have outperformed during the past 65 days, further indicating that we're on the path to economic recovery (Exhibit 2). Demand for industrial goods goes up as the economy strengthens and factories ramp up to deal with increasing consumer demand. And consumers that hunkered down during the recession start to spend again as they buy into the concept of an economic recovery.
Exhibit 2: Sector Performance, Feb 22 - May 24, 2010*
But with the market possibly at or beyond its peak, it may be time to sell industrials and consumer discretionary stocks and start rotating into the safety of the next sector most likely to outperform: energy.
According to the sector rotation model, even though the market is turning down, the economy is still ramping up. Increased business demand means higher energy usage. Increasing economic growth can also mean increasing inflationary pressures, making inflation-hedging precious metals attractive at this point in the cycle, too.
Economic Peak/Bear Market
As the economy hits its peak, usually demonstrated by rising interest rates and decreasing unemployment, it's time to rotate into recession-proof stocks like healthcare and consumer staples. And as the economy starts to enter recession, utilities become the next sector ready to outperform.
During recessions, sectors providing 'necessary' items flourish. Common sense says that the average person needs to stop discretionary purchases to focus on paying for the basics: utilities, pharmaceuticals, healthcare and non-cyclicals (like toothpaste and light bulbs).
Economic Contraction/Market Trough
As the economy works through the second half of a recession, it's already time to start looking forward to the recovery. This usually requires a good amount of discipline -- recessions are not pleasant, and few people are confident enough to start investing for the coming recovery. The end of a recession is usually the point of maximum pessimism.
But this is exactly the time to get greedy. The financial sector should be poised to outperform as the stock market looks forward to the increasing investment that will be needed to fund an economic recovery.
Economic Trough/Market Recovery
Finally, investors start rummaging through the wreckage of the recession to find bargains, and this buying process starts driving the markets higher. As consumers emerge from their recessionary bunkers, transportation stocks heat up and start moving inventory around the world. Businesses start investing in technology to replace the worn out or obsolete equipment they couldn't afford to replace during the recession. And then we find ourselves back where we started, riding up the bull market wave as the economy recovers.