Trends and fashions come and go in life and in the stock market, and that’s what sector rotation is all about. One type of stock is “hot” today but “not hot” a month later. This change is a normal part of the stock market because it works in cycles. And it might sound mysterious, but it’s possible to understand it. Or, better yet, you can learn to profit from it.
To make money from sector rotation, you’ll want to get a brokerage account. Specifically, you’ll need an account that allows you to buy and sell exchange-traded funds or ETFs. These are similar to mutual funds, and some of them represent stock-market sectors. So let’s delve into what this strategy means and how you can trade it.
What is a stock market sector?
Let’s start simple. A sector is a part of the economy. And as an investor, you can also view a sector as a part of the stock market. For example, there’s the energy sector of the economy. It includes companies that work with oil, natural gas, and coal—such as Exxon Mobil (XOM) and Chevron (CVX).
Another example is the financial sector, which mainly comprises of banks such as Bank of America (BAC) and Wells Fargo (WFC). However, the financial sector also includes non-bank companies that deal with managing money on a large scale. For instance, insurance companies like American International Group (AIG) and The Travelers Companies (TRV) tend to be part of the financial sector.
Other market sectors you should be aware of
- Utilities: This sector is mostly electric and power companies such as Duke Energy Corporation (DUK) and The Southern Company (SO).
- Technology: This sector includes computers, software, microchips, smartphones, and so on. Examples are Intel (INTC) and Microsoft (MSFT).
- Telecommunications (or telecoms): This sector includes service providers for phones, the Internet and streaming, and cable television. Examples are AT&T (T) and Verizon (VZ)
- Retail: Brick-and-mortar store chains like Macy’s (M) and JC Penney (JCP) are in this sector. Department stores like Walmart (WMT) and Target (TGT) are also part of the retail sector.
- Online retail: This comparatively new sector includes Amazon (AMZN) and Alibaba (BABA).
- Real estate: This sector includes Realty Income Corporation (O), Simon Property Group (SPG), and other real estate investment trusts.
- Healthcare: This sector includes healthcare providers like United Health Group (UNH) as well as drugstores like CVS (CVS).
- Biotechnology: Examples of companies developing new drugs and medical technologies include Gilead Sciences (GILD) and Biogen (BIIB).
- Home construction: This sector includes well-known companies like Home Depot (HD) and Lowe’s (LOW).
- Basic materials: This sector includes famous names like DuPont (DD) and Sherwin-Williams (SHW).
- Industrials: This sector involves companies that make things that don’t sell to the public. Think machinery and equipment, construction and manufacturing supplies, et cetera. Two examples would be Caterpillar (CAT) and Boeing (BA).
- Consumer staples: This sector comprises companies that sell basic goods to the public, such as Coca-Cola (KO) and Procter & Gamble (PG).
- Consumer discretionary: The companies in this sector sell items that are “wants” (sometimes including luxury items) rather than basic needs. This sector includes Nike (NKE) and Starbucks (SBUX).
This list isn’t comprehensive, so I encourage investors to explore other sectors of the stock market as well.
What is sector rotation?
As I explained earlier, the stock market involves cycles. The investing community will favor one sector for a while. Then they’ll dislike that sector and favor a different sector for a time. In other words, the market “rotates” in and out of the various sectors at different times.
Rotations can last for weeks, months, or even years. When the stock market is feeling “risk-on,” investors tend to rotate into riskier stocks. These riskier investments include the technology, retail and online retail, consumer discretionary, and (sometimes) biotechnology sectors. When investors are feeling “risk-off,” they tend to flock to less risky sectors. These less risky sectors include utilities, healthcare, and consumer staples.
We saw this sector rotation in action during the financial crisis of 2008–2009. The “high flyers” like technology stocks had made tremendous gains until the financial crisis. And the investing community had rotated into riskier stock sectors. However, they rotated out of those sectors quickly during the crisis. Then, they rotated into sectors that felt safer.
Using ETFs to profit from sector rotation
Most well-known stock-market sectors have ETFs that represent them. Here are a few examples:
- Energy Select Sector SPDR Fund (XLE)
- Financial Select Sector SPDR Fund (XLF)
- Utilities Select Sector SPDR Fund (XLU)
- Technology Select Sector SPDR Fund (XLK)
- Industrial Select Sector SPDR Fund (industrials) (XLI)
- Materials Select Sector SPDR Fund (basic materials) (XLB)
- Health Care Select Sector SPDR Fund (XLV)
- SPDR S&P Retail EFT (XRT)
- ProShares Online Retail ETF (ONLN)
- iShares U.S. Real Estate ETF (IYR)
- Consumer Staples Select Sector SPDR Fund (XLP)
- Consumer Discretionary Select Sector SPDR Fund (XLY)
- iShares Nasdaq Biotechnology ETF (biotechs) (IBB)
- iShares US Telecommunications ETF (IYZ)
These ETFs aren’t guaranteed to track or follow the sectors perfectly. However, they usually do a pretty good job of following the general movements of their respective sectors. You can check with your broker to see if they allow you to buy and sell these ETFs.
At any given time, some of these ETFs will be out of favor, and their prices will be down a lot. Others will have a lot of favor from investors and be relatively expensive. Some of them, meanwhile, will just be neutral.
Mastering a sector rotation strategy
The idea with sector rotation is to sell the heavily-favored sector ETFs if you own them. Then you can buy the sector ETFs that are out of favor. Hopefully, in due time, those out-of-favor sectors will regain investor favor and go back up. That’s the time to sell them and start looking for less favorable sectors to park your investable money.
It takes guts to buy stock-market sectors that most investors are selling. However, that’s the crux of the “buy low, sell high” philosophy. Billionaires like Warren Buffett and John C. Bogle became very wealthy with this approach.
Rotating in and out of stocks requires you to check the comparative prices of sector ETFs. And you’ll also need to gauge market sentiment and what’s in and out of favor. Most of all, you’ll need the courage to buy what’s not popular at the moment. If you have what it takes for sector rotation, however, you could prosper in the long term—regardless of what’s hot and what’s not.
Looking for more personal finance guidance? Check out How to Profit When the Stock Market Goes Down.