Sector Rotation

http://www.cxoadvisory.com/blog/external/blog7-10-07/

July 10, 2007 - Perfect Sector Rotation

Is the conventional wisdom that stocks of different sectors outperform systematically during different phases of the business cycle correct, and exploitable? In their July 2007 paper entitled "Sector Rotation over Business-Cycles", Jeffrey Stangl, Ben Jacobsen and Nuttawat Visaltanachoti test a sector rotation strategy that times U.S. sector stock holdings over U.S. business cycles, as defined by the National Bureau for Economic Research (NBER). The conventional sector outperformance wisdom they evaluate comes from Standard & Poor's Guide to Sector Investing 1995. Using monthly industry returns, market returns and Treasury bill rates for 1948-2006 (nine complete business cycles), they find that:

• Industry returns exhibit the same general pattern as market averages, lowest during business cycle Stage IV and highest during Stage V. Actual industry performance based on nominal returns across business cycle stages partially confirms conventional wisdom. (See the business cycle model and table of industries-sectors below.)
• A sector rotation strategy based on conventional wisdom and perfect hindsight for timing stages of the business cycle produces a marginal 2.1% annual Jensen’s alpha. This hypothetical outperformance would likely not survive exclusion of hindsight and inclusion of transaction fees.
• The performance of sector rotation is inconsistent across the business cycle. During early and middle expansion (Stages I and II) "favored" sectors underperform the market, with negative Jensen's alphas of -5.3% and -1.0%, respectively. During early recession (Stage IV), sector rotation strongly outperforms, with a Jensen’s alpha of 10.3%.
• An alternative, much simpler market timing strategy that is fully invested in the broad market during Stages I, II, III and V and in cash during Stage IV hypothetically beats a sector rotation strategy over the same period in terms of cumulative wealth and Sharpe ratio. (See last chart below.)

The following figure, taken from the paper, is an idealized NBER-style business cycle divided into five stages as done in other studies. Expansions span trough to peak in Stages I-III; recessions, peak to trough in Stages IV-V. As indicated, expansions are typically much longer than recessions.

The following table, also from the paper, summarizes the conventional wisdom (based on Standard & Poor's Guide to Sector Investing 1995) relative outperformance of sectors by stage of the business cycle.

The next figure, again from the paper, shows cumulative wealth from an initial investment of one dollar over the period 1948-2006 for: (1) a "Market" strategy that holds the market portfolio for the entire period; (2) a "Sector Rotation" hypothetical (perfect hindsight) strategy that holds sector portfolios in equal weights during the business cycle stage in which conventional wisdom says they are optimal; and, (3) a "Market Timing" hypothetical (perfect hindsight) strategy that holds the market portfolio during business cycle Stages I, II, III and V and cash during Stage IV. It shows that the simpler "Market Timing" hypothetical strategy has greater potential than "Sector Rotation." It also shows that both hypothetical timing strategies would beat buy-and-hold for an investor/trader who can accurately anticipate business cycle phases.

The authors note that NBER tracks only business cycle turning points (peaks and troughs), not the five phases defined above, and NBER can take as long as two years after a turning point to designate its date. They also note that one business cycle can be very different from another.

http://www.investopedia.com/articles/trading/05/020305.aspEconomic Cycle in Four Stages

Here is a list, in the same order as above, of four basic stages of the economic cycle, and some associated telltale signs - again, keep in mind that these usually trail the market cycle by a few months.

• Full Recession - Not a good time for businesses or the unemployed. GDP has been retracting, quarter-over-quarter, interest rates are falling, consumer expectations have bottomed and the yield curve is normal. Sectors that have historically profited most in this stage include:
  • Cyclicals and transports (near the beginning).
  • Technology.
  • Industrials (near the end).
• Early Recovery -Finally, things are starting to pick up. Consumer expectations are rising, industrial production is growing, interest rates have bottomed and the yield curve is beginning to get steeper. Historically successful sectors at this stage include:
  • Industrials (near the beginning).
  • Basic materials industry.
  • Energy (near the end).

• Late Recovery -In this stage, interest rates can be rising rapidly, with a flattening yield curve.Consumer expectations are beginning to decline, and industrial production is flat. Here are the historically profitable sectors in this stage:
  • Energy (near the beginning).
  • Staples.
  • Services (near the end).
• Early Recession -This is where things start to go bad for the overall economy. Consumer expectations are at their worst; industrial production is falling; interest rates are at their highest; and the yield curve is flat or even inverted.Historically, the following sectors have found favor during these rough times:
  • Services (near the beginning).
  • Utilities.
  • Cyclicals and transports (near the end).

http://www.stockcharts.com/charts/performance/SPSectors.html

This theoretical model is based on Sam Stovall's S&P's Guide to Sector Rotation and states that different sectors are stronger at different points in the economic cycle. The graph above shows these relationships and the order in which the various sectors should get a boost from the economy. The Market Cycle preceeds the Economic Cycle because investors try to anticipate economic effects. The PerfChart at the top of this page tries to help you see this effect.

Stage:	Full Recession	Early Recovery	Full Recovery	Early Recession
Consumer Expectations:	Reviving	Rising	Declining	Falling Sharply
Industrial Production:	Bottoming Out	Rising	Flat	Falling
Interest Rates:	Falling	Bottoming Out	Rising Rapidly (Fed)	Peaking
Yield Curve:	Normal	Normal (Steep)	Flattening Out	Flat/Inverted

Investors beat the market when they are in the right sector at the right time. The problem is deciding when to make the transition to a sector that has greater potential. Moving one's capital to a new sector too early will result in weak performance at best with losses more likely. On the other hand, if one is late getting into the sector you miss much of the uptrend and miss most of the profit opportunity.

One of the key elements of the sector rotation strategy is to hold shares in more than one sector. The idea is to buy into the sector that is rising toward the top and then hold it until it turns down. As a sector turns down an investor rotates their money to the next sector that is rising toward the top and is expected to outperform. This strategy often means an investor will be holding a minimum of three sectors in their portfolio; one sector on the rise, one at the top and one that is starting to decline.

A sector rotation strategy can produce excellent opportunities, if you follow a sector rotation model that reflects the current economic and industry situation. Each business cycle tends to have different affects on specific industry groups. Each recession and bear market tends to have a more significant affect on one or two industries. The impact on these industries can be enough to cause them to lag behind during the following economic recovery. Moreover, a new economic quandary causes industry sectors to react in new and different ways. As a result, the rotation of the sectors in the model may not play out as depicted.

Current Sector Rotation Analysis

In anticipation of a recovery in the economy, it is appropriate to perform an analysis of the sector rotation model in light of the current recession. According to the sector rotation model, the technology sector is one of the first sectors to recover from a recession and bear market. However, following the dot.com bust of 2000, many companies in the technology sector failed to rebound as quickly as indicated by the model. The impact of the bear market on the technology sector was extensive. Many companies disappeared completely. Others struggled to survive. Eventually a number of the technology companies began to thrive, however it took several years before doing so. Those investors that followed the standard sector rotation model were disappointed when they realized that the sector did not perform, as the sector rotation model would indicate.

This raises the question – What sectors will be the best performers when the bear market that began in December 2007 finally ends? The place to begin to answer this question is to analyze the affect of the current recession on the sector rotation model.

The table below is a high-level analysis of the nine S&P 500 sectors as the might perform once the current bear market is over. A recession affects the business model of a company, some positively, some negatively. In addition, recessions can harm the financial strength of companies as they struggle to survive. Finally, government actions can cause changes in the way companies operate within the sector. Some of these government actions are attempts to help the economy recover. Other government actions are the result of new policies by the current administration. These policies may not be directly from the recession, yet they can have a significant influence on the industry.

Sector	Changed Business Model due to Recession	Financial Strength	Government Influence	Summary Affect
Consumer Discretionary	Partial due to affect of de-leveraging of households. Companies catering to the wealthiest individuals may also see an impact as compensation returns to more natural levels.	Curtailed in the near future. Cannot count on expanding credit to fund spending.	Attempts to stimulate spending may not have the desired affect as consumers shore up their savings and reduce debt.	Slightly negative. Likely to hinder response of the sector to recovery of the economy.
Technology	Minor change due to lower spending by consumers.	Many companies are financially strong with significant amounts of cash on their balance sheets.	Might see some positive influence from higher investment in energy efficiency and other government-funded programs.	Positive. Sector is well positioned to take advantage of the economic recovery.
Industrial	Could be significant depending on the sub-sector and company. Some companies are likely to recover stronger, while others will be weaker and some will not survive.	Varies by sub-sector and company. Some firms have the significant financial strength, while others are very weak (autos).	Not significant, unless the company received government bailout money. Longer term, some firms could be affected by the move to greener energy. Some of the stimulus money will have positive affect on the engineering and construction firms.	Mostly neutral, though some sub-sectors and companies are and will feel dramatic positive and negative affects.
Materials	Minor affect. While the sector is experiencing losses, this is normal during a recession.	The large firms are well positioned and are likely to benefit, as new sources of minerals are not coming online, limiting supply.	Not likely to see much change. Longer term the issues with carbon emission could be more of a problem.	Neutral to positive. Lack of investment in new sources of minerals and materials is likely to result in higher prices and profits.
Energy	Recession is having minimal affect on the sector. Move to new energy could be more significant eventually.	Strong. Cash flows remain very positive and a recovery of the economy will drive up prices and profits.	None from the recession. However, could be significant as the movement to green energy heats up. Should prices rise to high, we could see new government initiatives.	Positive from the recession. Sector is likely to do well though the green initiatives could become a problem. If prices climb to high, we could see negative consequences as well.
Consumer Staples	No significant change.	Companies remain financially strong.	Minor changes.	Neutral.
Health Care	New investment and new regulations will have a dramatic long term affect. Insurance will see the biggest impact. Big pharmaceuticals will also see some negative impact. Bio-technology is likely to see a positive impact from investment in new ways to fight disease.	Neutral. Most firms have the financial strength to recover. Moreover, if everyone can receive coverage for healthcare there should be a large increase in the overall revenues to many firms.	Significant. Government will be much more involved in paying for healthcare and changes to regulations.	Some positive and some negative.
Utilities	Movement to lower carbon emissions model will negatively affect many companies, while raising costs.	Relatively strong as many are regulated firms.	Expect carbon emission standards to become reality.	Negative.
Finance	Significant affect on ability to lend with a return to the more strict lending rules.	Weakened significantly, as governments have had to step in to prop up many of the larger institutions. Paying back these “loans’ will take time and cost the companies for years.	Expect more government oversight and rules	Strongly negative. Some banks that have been able to avoid the affect of the toxic assets will do well.

Overall, we should expect to see important differences in the way sectors and companies respond to a recovery from the recession and the bear market. The massive de-leveraging process will influence any expansion in consumer spending. Those sectors and companies that depend on the consumer will struggle, as they save more and lower their debt. The technology sector should do well in the recovery. The consumer discretionary, a cyclical industry, should recover, though the affects of restrained consumer spending is likely to restrain their resurgence. The materials and energy sectors should also do well. The industrial sector will have a mixed recovery, depending on the sub-sector and individual companies.

The financial sector will experience long-term difficulties as it recovers from the affects of the massive losses and new government regulation. Healthcare will see significant changes that will have positive and negative affects, depending on the sub-sector. Utilities will continue to feel the affects of the reduction in carbon emissions and the investments necessary to create a new energy environment. Consumer staples will continue to operate as before.

The Bottom Line

Your sector rotation strategy depends on your analysis of the affects of the current recession on each sector. This analysis of each sector’s rotation provides you a more informed investing strategy. Adjusting your sector rotation strategy to reflect the current analysis of the affects of the most recent recession will help to position your portfolio to benefit the most from the new bull market.