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What is Sector Rotation Theory?

Investors can gain from the premise that different sectors do well during different stages of the economic cycle

The economy goes through cycles: it expands for a few years and then contracts. Study of historical data suggests that different sectors tend to perform well on the stock markets during different stages of the economic cycle. While history never repeats itself exactly, some broad patterns tend to recur. Investors can take advantage of the sector rotation theory to move their money from those sectors that have seen their best times to those that are likely to do well in future.

The person who developed the sector rotation theory is Sam Stovall, chief investment strategist at Standard & Poor’s. He developed this theory by studying data on economic cycles going as far back as 1854 provided by the National Bureau of Economic Research (NBER) of the US.

When trying to correlate stock-market performance with economic performance, one should remember that the stock market is a forward indicator. It factors in (or, in market parlance, discounts) today what will happen in the economy about three to six months in the future. Hence the market cycle leads the economic cycle.

Four stages of the economic cycle
Below we discuss the four stages of the economic cycle and the signs that can help us identify these stages.
Early recovery: The US economy is in this stage currently. Here, consumer demand begins to recover and so does industrial production. This is a period of easy monetary policy (interest rates are at or near their bottom). The yield curve begins to get steeper.
Interest-rate sensitive sectors (banking) and the consumer discretionary space (consumer durables, auto) and technology tend to do well during this phase.
Late recovery: By now inventory levels are low and manufacturers begin to face capacity constraints, forcing them to undertake capital expenditure to expand capacity. The capital goods sector benefits from this development. This stage is often marked by high inflation (owing to increase in input costs). Hence sectors such as commodities and energy do well.
To bring inflation under control, the central bank begins to ratchet up interest rates. The Indian economy appears to be in this stage currently.
Early recession: This is the stage when the economy begins to do badly. Consumer expectations are at their nadir, hence demand declines. Industrial production follows suit. Interest rates tend to be at or near the peak. The yield curve is either flat or inverted.
Historically, the following sectors do well in these turbulent times: services (at the beginning), utilities and cyclicals (late stage).
Full recession: This is a period when demand is low, so businesses underperform and some even close down. Unemployment levels soar. To counter these developments, the central bank cuts interest rates. The yield curve tends to have a normal shape.
In this stage investors turn to defensive sectors such as FMCG and Pharma.
One should, however, use this theory bearing in mind a couple of caveats. One, the different stages are not clearly demarcated and there is considerable overlap between them. And two, in the next expansion or recession some sectors may not perform as predicted by the theory owing to some extraneous factors.

Where are we now?
A recent report from Ambit Capital suggests that India is presently in the late stage of a bull run (the current bull run is about two years old). A study of sectoral returns done by the brokerage house shows that consumer discretionary (consumer durables and auto), financials and technology have done well in the past six months to one year. Indexes for sectors such as capital goods, oil and gas, metals, and power, on the other hand, have lagged behind the Sensex over this period.
Based on the sector rotation theory, the brokerage house suggests that investors should invest more in capital goods and commodities (energy and metals) hereafter.

What is the yield curve?
The yield curve is a powerful forward indicator of what lies ahead in the economy and the markets

The yield curve is another powerful predictor of what is likely to happen in the economy and the markets and can be used by investors to improve their investment performance. The yield curve is said to predict 12 months in advance what will transpire in the economy.

The yield curve basically plots the different maturities of bonds on the x-axis and their yields on the y-axis.

A normal yield curve is upward sloping: bonds with higher maturities offer a higher yield to investors than those with lower yields. This is keeping with the time value of money.

A positively sloping yield curve indicates that short-term rates are low. This indicates that the central bank is pursuing an accommodative or loose monetary policy. This lowers the cost of borrowing for both corporates (and hence encourages investment) and individuals (encouraging consumption). As a low interest-rate regime spurs demand, it presages good times ahead for the economy and the markets.

A negatively sloping yield curve, on the other hand, indicates that the central bank has raised short-term interest rates high. This is usually done in response to high inflation. By raising rates, the central bank tries to reduce demand (also referred to as ‘cooling’ the economy) by making borrowing more expensive. Sometimes, irrational exuberance in asset markets (stock or property market) can also cause the central bank to raise rates in order to prick the bubble forming in these markets.

A negatively-sloping yield curve usually indicates poorer economic and market conditions ahead. Whenever the yield curve becomes negatively sloping, it is invariably followed by either an economic slowdown or by an out-and-out recession.

When the yield curve is negatively sloping, it is a strong signal to investors to diversify their holdings out of the equity markets and thus avoid losing their past gains.