Sector rotation

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Sector rotation is a theory of stock market trading patterns. [1] In this context, a sector is understood to mean a group of stocks representing companies in similar lines of business. The basic premise is, that these stocks can be expected to perform similarly. Additionally, different groups of stocks which have been clustered according to the aforementioned principle will show a different performance.

Stock market public entity for the trading of company stocks and shares

A stock market, equity market or share market is the aggregation of buyers and sellers of stocks, which represent ownership claims on businesses; these may include securities listed on a public stock exchange, as well as stock that is only traded privately. Examples of the latter include shares of private companies which are sold to investors through equity crowdfunding platforms. Stock exchanges list shares of common equity as well as other security types, e.g. corporate bonds and convertible bonds.

Contents

Sector rotation theory says a number of things. First, whatever sector is hot (has done well recently) should continue to outperform. Second, these sectors will eventually rotate so that whatever was once out of favor will be in favor. Third, these movements are somewhat predictable, and connected with the business cycle.

The business cycle, also known as the economic cycle or trade cycle, is the downward and upward movement of gross domestic product (GDP) around its long-term growth trend. The length of a business cycle is the period of time containing a single boom and contraction in sequence. These fluctuations typically involve shifts over time between periods of relatively rapid economic growth and periods of relative stagnation or decline.

With the phase-shift in the performance cycle of sectors (ideally like the phase-shifted wave patterns of three-phase electric power) an investor could continually hop from a sector at the peak of performance to a sector showing a potential to rise.

Three-phase electric power Common electrical power generation, transmission and distribution method for alternating currents

Three-phase electric power is a common method of alternating current electric power generation, transmission, and distribution. It is a type of polyphase system and is the most common method used by electrical grids worldwide to transfer power. It is also used to power large motors and other heavy loads.

A sector rotation investment strategy is not a passive investment strategy like indexing, and requires periodic review and adjustment of sector holdings. Tactical asset allocation and sector rotation strategies require patience and discipline, but have the potential to outperform passive indexing investment strategies.

Tactical asset allocation (TAA) is a dynamic investment strategy that actively adjusts a portfolio's asset allocation. The goal of a TAA strategy is to improve the risk-adjusted returns of passive management investing.

Examples

An investor or trader may describe the current market movements as favoring basic material stocks over semiconductor stocks by calling the environment a sector rotation from semiconductors to basic materials.

A semiconductor material has an electrical conductivity value falling between that of a conductor, such as metallic copper, and an insulator, such as glass. Its resistance decreases as its temperature increases, which is the behaviour opposite to that of a metal. Its conducting properties may be altered in useful ways by the deliberate, controlled introduction of impurities ("doping") into the crystal structure. Where two differently-doped regions exist in the same crystal, a semiconductor junction is created. The behavior of charge carriers which include electrons, ions and electron holes at these junctions is the basis of diodes, transistors and all modern electronics. Some examples of semiconductors are silicon, germanium, gallium arsenide, and elements near the so-called "metalloid staircase" on the periodic table. After silicon, gallium arsenide is the second most common semiconductor and is used in laser diodes, solar cells, microwave-frequency integrated circuits and others. Silicon is a critical element for fabricating most electronic circuits.

An example of a sector clustering would be: [2]

Leading
This includes stocks like consumer cyclicals and financial companies. These would do well when the market is at bottom.
In-line
This includes stocks like technology and telecommunication. These should go up more than the overall market in the main part of a bull market.
Lagging
This includes stocks like energy companies. These would do well when the market is at top.
Contrarian
This includes consumer staples. These should do least bad in a bear market.

Note that the performances mentioned are always relative to the overall market. During a bear market it is expected that all stocks will go down some.

Connection with other markets

The primary driver of sector rotation is the variability of currency values (inflationary, disinflationary, or deflationary) 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 contract, reducing 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. The relative strength of commodities, bonds, currencies, and stocks shift in this changing monetary climate in a somewhat predictable manner. [3]

A currency, in the most specific sense is money in any form when in use or circulation as a medium of exchange, especially circulating banknotes and coins. A more general definition is that a currency is a system of money in common use, especially for people in a nation. Under this definition, US dollars (US$), pounds sterling (£), Australian dollars (A$), European euros (€), Russian rubles (₽) and Indian Rupees (₹) are examples of currencies. These various currencies are recognized as stores of value and are traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are defined by governments, and each type has limited boundaries of acceptance.

Saying

"The worst house in a good neighborhood is better than the best house in a bad neighborhood."

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