Beating The Market With Sector Rotation

As an investor, how can you benefit by applying the strategy of sector rotation, a concept that offers an approach to achieving substantial gains in the stock market by aligning investments with different phases of the economic cycle? Unlike market timing, which often proves to be a challenging and less effective strategy, sector rotation leverages the inherent cyclical nature of the economy and the varying performances of sectors during different stages of the economic cycle. The article throws more light on this investing tool 

If you ask an investor about the best way to achieve substantial gains in the stock market, he would likely respond with “market timing!”. This technique, which involves buying low and selling high by perfectly predicting market peaks and troughs, is often hailed as the ultimate strategy. However, while their enthusiasm might be high, their answer would be misguided. Market timing, despite its allure, is a notoriously difficult skill to master and predict it precisely and consistently has proven to be less effective than a more reliable strategy – sector rotation. 

A study conducted by an investment research firm based in the U.S. analysed the performance of three investment strategies over a decade—market timing, sector rotation and the ‘buy and hold’ approach. In this study, market timing was defined by accurately predicting significant market movements of 10 per cent or more – buying when the prices were set to rise and selling when they were poised to fall. The sector rotation strategy, on the other hand, involved concentrating the entire portfolio in one of six sectors—energy, financial services, gold, healthcare, technology, or utilities—at the start of each year. 

Meanwhile, the ‘buy and hold’ approach simply held a diversified portfolio of S&P 500 stocks throughout the 10-year period. The findings? Sector rotation outperformed market timing by more than four to one, proving that while market timing may capture the imagination, it’s the disciplined, strategic allocation of capital across different sectors that can truly generate alpha and deliver market-beating returns. You might wonder, “Is this really possible?” Well, according to investment guru Peter Lynch, it absolutely is. 

He famously said, “If you are in the right sector at the right time, you can make a lot of money real fast.” Consider the Nifty Bank index during the period 2002 to 2007. It surged by an impressive 3.1 times, with not a single year in that span showing negative returns. In comparison, the broader Nifty 500 index increased by 2.5 times, and the Nifty 50 index doubled. 



 

This stark difference in performance underscores the power of sector rotation. Investors who strategically allocated their capital to the banking sector during this period reaped significantly higher rewards than those who stuck with broader market indices. It’s a vivid example of how timing your investments within the right sector can yield substantial returns, far outpacing more conventional strategies. 

Now, if you are on the wrong side of the sector rotation you will have a diametrically opposite result. Take a moment to consider the IT sector at the start of the millennium. Investors who poured their money into IT stocks, riding high on the sector’s stellar performance in the late ‘90s, found themselves facing years of stagnation. The IT index struggled for the next two years and took even longer to recover. Similarly, those who jumped into the pharmaceutical sector in around 2015, impressed by its remarkable run between 2012 and 2015, were left disappointed. The sector delivered negative returns for the next four years, and it wasn’t until the corona virus pandemic that investors saw a break-even point. 

The table below shows the performance of different indices in different years. You can see Nifty PSU Bank index, which has been on a tear in the last few years, has generated negative return between 2018 and 2020. For the calendar year 2020, the index had given negative return of 31 per cent. 

Understanding Sector Rotation 

These examples underscore the importance of a strategic approach known as sector rotation. Before we begin, it is necessary to understand two key components: sectors and industries. Many of us use these terms interchangeably. But they are not the same. A sector is a group of industries that have similar fundamental characteristics, whereas an industry is a collection of companies with similar primary lines of business. For example, oil and gas may be a single sector covering industries such as refineries, oil exploration and petrochemical, among others. 

According to IBD founder William O’Neil’s research, 37 per cent of a stock’s price performance is tied to the industry group that it is in and an additional 12 per cent from the industry sector’s performance. Sector rotation isn’t about chasing the latest trend. Rather, it’s about being strategic and aligning your investments with the different phases of the economic cycle. 

By shifting your focus to sectors poised to benefit from the current economic environment, you can position yourself to generate alpha—those elusive, market-beating returns. This strategy involves shifting investments between different market sectors based on changing economic conditions and the anticipated performance of those sectors during specific stages of the economic cycle. 

Sector Rotation and Economic Cycles 

The economy follows a relatively predictable pattern known as the economic cycle, consisting of broadly four phases: expansion, peak, contraction, and trough. Each phase impacts industries and companies differently, which is where sector rotation becomes crucial. It’s important to note that the stock market doesn’t move in perfect sync with the economic cycle. Investors, always forward-looking, make decisions based on their expectations of the next phase in the cycle. As a result, the stock market typically leads the economic cycle by several months. 

For example, during economic expansion, sectors like consumer discretionary—encompassing industries such as automobiles and luxury goods—often outperform as rising economic growth drives the demand for non-essential goods. Conversely, during economic downturns, defensive sectors like utilities and healthcare, which offer essential services regardless of economic conditions, tend to attract more investor interest. 

It is a well-established fact that stock markets are leading indicators of the business cycle, often anticipating economic shifts by 6-9 months. Key economic indicators, such as GDP, industrial production, interest rates and the yield curve, provide valuable insights into the economy’s direction and help gauge future stock market performance. 

The chart above overlays the economic cycle with the market cycle, with the market cycle shifted forward by approximately six months, reflecting its historical tendency to lead the economic cycle. While this is a generalisation and current conditions could differ, history provides valuable insights. By examining past patterns, we can gather clues about where we might be in the current market and economic ‘seasons’ 

The primary driver of sector rotation is currency value, inflation level, and interest rates. As the economy expands, demand for raw materials creates inflationary pressures, which in turn prompt higher interest rates, which increase the value of the currency, which reduces the competitiveness of a country’s exports as the currency causes them to cost more to other countries. 

This final stage causes the economy to slow down, reducing the demand for raw materials, which creates deflationary pressures, which in turn prompt lower interest rates, which decrease the value of the currency, which increases the competitiveness of a country’s exports—creating a new market cycle. 

Sector Investing 

Now that we understand how sectors are linked to the economic cycle, we can dive into sector investing—a concept as straightforward as it sounds. Think of it like an inverted pyramid: sector investing begins with an analysis of the broader global economic outlook and narrows down to identifying specific stocks worth buying. At the ‘big picture’ level, investors assess key factors such as, “Where are we in the economic cycle?” “Have interest rates peaked?” and “Is inflation accelerating?”. 

Once these foundational assumptions are made, the next step is to determine which industries will benefit from the upcoming economic changes through accelerated earnings growth—these are the industries to invest in, as a company’s earnings outlook is a key driver of its stock price. Conversely, industries that are likely to grow at a slower pace should be avoided. The final step involves selecting companies within the favoured industries that are projected to perform the best. 

Sector investing follows a ‘top-down’ approach, starting with the economy and working down to specific sectors and stocks. This contrasts with ‘bottom-up’ investing, where stock selection is primarily based on an analysis of company-specific fundamentals and technical factors. Both strategies have their merits, but to begin sector investing, we start at the top—with the economy and its impact on industry performance. 

Let’s understand the above with an example. For instance, the emphasis by the Indian government on infrastructure development in last few years where government’s spending on this sector has increased by almost three times since 2020. This clearly signals the potential for a deep-dive analysis into the infrastructure sector and the stocks within it, as these could benefit significantly from favourable government policies and increased spending. Many of the companies such as Larsen and Toubro , IRB Infra and HG Infra, among others, have become multibaggers. 

From Macro to Micro 

Identifying the leading sectors and pinpointing the current phase of the economic cycle is easier said than done. As discussed earlier, we can gain insights into the economic cycle by analysing the relative outperformance of various indices. To do this, we will calculate the 55-day and 200-day relative performance of major equity indices against the Nifty 50. 

Over the last 200 days, Nifty CPSE, which includes primarily PSU companies, has shown the strongest outperformance, followed by realty, energy and automobiles. The outperformance of PSUs is largely a catch-up rally, as these stocks had been underperforming for an extended period. Based on this sectoral outperformance, we believe the market may be nearing the top of a bull market. 

Analysing the data from the last 55 days, a different picture emerges. Defensive sectors such as IT, pharmaceutical and FMCG have outperformed, indicating that the market might be entering a phase of subdued returns. 

Crystal Ball Gazing 

Now, we will aim to identify the sectors and companies likely to outperform in the future based on the factors discussed above. This approach is similar to tactical asset allocation, but instead of shifting between asset classes and liquidity, the focus is on reallocating funds based on the expected performance of sectors and companies. Predicting sector rotation is feasible because markets tend to move in reasonably predictable cycles, with certain industries leading during each phase of the cycle discussed above. 

To identify the sectors and companies likely to perform well going forward, we analyse the BSE 500 constituents using a combination of technical indicators. We use the Relative Strength Index (RSI), a momentum indicator that measures the speed and change of price movements to capture momentum and Simple Moving Averages (SMA) over 20, 50, and 100 days to define the trend. RSI greater than 50 indicates momentum and a higher number of stocks trading above the 20-day SMA suggests short-term bullish momentum, the 50-day SMA indicates medium-term bullish momentum, and the 100-day SMA reflects long-term bullishness. 

Sectors Showing Good Momentum Currently* 

Sector rotation involves shifting investments between different industry sectors based on the economic cycle. 1) As the economy progresses through stages like expansion, peak, contraction, and trough, different sectors outperform. 2) By identifying these trends and reallocating investments accordingly, investors aim to capitalize on sector performance. 3) To apply this strategy, closely monitor economic indicators, analyze industry trends, and research historical sector performance. Utilize ETFs or individual stocks to gain exposure to specific sectors. 4) Remember, successful sector rotation requires timely decision-making and a deep understanding of market cycles 

The below table has been filtered based on key technical indicators, specifically RSI and SMA, to identify sectors with positive momentum. Out of 45 sectors, we selected seven sectors based on percentage (at least 60 per cent) of companies whose RSI and SMA are greater than 50 per cent. Among, the sectors analysed, business services, which includes companies like CDSL and BSL, among others, stands out along with IT and healthcare. 

With more than 60 per cent of the companies in this sector showing SMA and RSI values greater than 50, it indicates a strong upward trend. Additionally, the sector has demonstrated impressive fundamental performance with an average PAT (profit after tax) growth in double digits and consistent revenue growth of TTM (trailing twelve months). 

In conclusion, sector rotation offers a strategic approach to achieving substantial gains in the stock market by aligning investments with different phases of the economic cycle. Unlike market timing, which often proves to be a challenging and less effective strategy, sector rotation leverages the inherent cyclical nature of the economy and the varying performances of sectors during different stages of the economic cycle. 

By carefully analysing economic indicators and identifying sectors poised for growth, investors can position themselves to generate alpha and outperform the market. As demonstrated by historical examples and technical analysis, understanding and applying sector rotation can lead to significant investment returns, making it a valuable tool for both seasoned and novice investors alike. 

Painting A Larger Picture 

Sector rotation isn't something that plays out over a few days, weeks, or even months—it often spans several years. For example, the Pharma sector experienced sustained outperformance for four years before it eventually cooled off. Similarly, if we look back further, private sector banks saw massive outperformance between 2008 and 2017, with their weightage in the Nifty 50 increasing from 5.6 per cent to 24.3 per cent. 

It can also work the other way around. For instance, after the dotcom bubble, tech companies held a dominant position in the Nifty 50. However, following the crash, their weightage was cut in half over the next ten years. 

The following graphs provide a snapshot of the relative three-year rolling performance of various sectors against the Nifty 50 over the last 20 years, excluding Nifty Realty. These charts will allow you to draw your own conclusions and insights.