Sector Rotation: A More Active Approach to Stock Diversification

As the U.S. economy recovers from the effects of the COVID-19 pandemic, some industries are more likely to benefit than others. For investors looking to take a more active approach to stock diversification—that is, beyond a broad-based index fund—a so-called sector rotation strategy is one way to go.

With this approach, you overweight or underweight various sectors in your portfolio against a benchmark weighting—say, the S&P 500® Index—based on their expected performance. (The 11 equity sectors are Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Real Estate, and Utilities.)

Let’s look at the macroeconomic and sector-specific forces that can influence which sectors outperform—along with how to implement a sector rotation strategy in response.

1. Secular trends

These trends typically take 10 years or more to unfold and can have wide-ranging implications for the economy. Examples include:

  • Demographic trends that affect the economy, such as the long-term decline in interest rates and dwindling homeownership.
  • The effect of new technologies on businesses and consumers, such as the rise of e-commerce.
  • Changes in social behaviors that can disrupt legacy industries, such as the growing interest in green energy.
     

2. The business cycle

Every three to seven years, on average, the economy rotates through a four-stage business cycle:

  • Recovery, in which the economy is rapidly rebounding from a recession.
  • Expansion, in which the economy is growing at a moderate rate.
  • Slowdown, in which economic growth has peaked and then slows.
  • Recession, in which economic output is declining.

While no two business cycles are precisely alike, certain sectors tend to consistently outperform during particular stages of the cycle (see “Business cycles and sectors,” below).

3. Market cycles

While the equity market tends to rise during the growth stages of the business cycle and fall during the contractions, shorter-term ups and downs in the market cycle can be the result of a wide range of inputs, from changes in Federal Reserve policy and geopolitical events to surprising economic reports and swings in investor sentiment. When assessing the impact of the overall market’s direction on certain sectors, it helps to group them into two categories:

  • Cyclical sectors tend to outperform when the market is rising. These include Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials.
  • Defensive sectors tend to outperform when the market is falling. These include Consumer Staples, Health Care, and Utilities.

Furthermore, some sectors—including Financials, Real Estate, and Utilities—are more sensitive to interest rates, while the Energy sector can be swayed by the price of oil, irrespective of the market’s overall trajectory.

4. Sector-specific features

It’s important to scrutinize any investment’s underlying financial strength, as well as its performance relative to the market. At Schwab, we evaluate sectors using the following features:

  • Fundamentals: A sector’s fundamentals—such as earnings expectations and return on equity—can provide insight into its relative health.
  • Valuations: Comparing a sector’s current valuation against its historical average can provide insight into its relative worth.
  • Relative strength: A sector’s recent performance can provide insight into its price momentum compared with the overall market.

Implementing sector rotation

Once you’ve evaluated secular trends, the business and market cycles, and the sector-specific features currently at play, you can look for opportunities and compare your allocations to those of a broad-market benchmark.

For example, say you’ve determined that we’re in the expansion phase of the business cycle—which historically favors Consumer Discretionary, Financials, Industrials, and Information Technology—and that the other macroeconomic and sector-specific features are making Financials and Information Technology stocks particularly attractive. Now it’s time to adjust your portfolio’s sector allocations accordingly.

Let’s say you’re underweight in Financials and appropriately overweight in Information Technology relative to the S&P 500. Apart from using cash to overweight your Financials, you can shift your sector allocation in one of two ways:

  1. Sell a proportional amount of other holdings to purchase Financials stocks—but be sure to account for the impact on other sector allocations. (Selling shares of an S&P 500 index fund, for example, would also reduce your Information Technology holdings because such stocks make up roughly a quarter of the index.)
  2. Purchase individual sector funds in proportion to the allocations of a broad-market benchmark—and then buy or sell such funds to, in this example, overweight Financials and Information Technology.

Whichever method you choose, consider transaction costs and taxes, as well as operating-expense ratios if you’re using index funds to implement your strategy. Additionally, make sure that upping your exposure to more-volatile sectors, such as Energy and Financials, doesn’t increase your risk beyond what you can comfortably tolerate.