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  • Writer's pictureNathan Stoll

Why Sector Rotation Makes So Much Sense

Two Methods of Investing

While there are many ways to invest, there are two general approaches to investment strategies. The first approach is called buy and hold investing and is also known as passive investing. An investor with this type of strategy buys certain stocks, bonds, ETFs, mutual funds etc. and holds them long term without changing their allocation. This style can be modified to allow for long-term periodic adjustments.

The second style is called active investment management and utilizes more frequent changes in allocations. Its goal is to optimize upside performance while lowering downside stock market risk.

What is Sector Rotation?

Sector rotation is a specific methodology within the active management style. There are 10 broad sectors within the US economy. On rare occasions, these sectors are correlated and move in the same direction. However, those times are rare. Most frequently, some sectors in the economy have gains while others have losses. While there are no guarantees, these sectors seem to rotate in and out of favorable and unfavorable gain/loss positions.

According to portfolio manager, Matt Erickson, in his Seeking Alpha article, How to Beat the Market with Sector Rotation, those sectors with the most gains seemed to lose ground during the subsequent time period – and those with the most losses, tended to recover. This assessment needs a couple of caveats; while this pattern does not always hold true, it does TEND to be the case. Based on my research, some sectors, such as those tied to oil, commodities and interest rates are an exception to this pattern. Generally speaking, sectors pertaining to consumer and consumer behavior trend in an upward direction after a fallback. The pattern is known as mean reversion or sector rotation. I observed that this pattern tends to occur whether considering a daily, weekly or monthly perspective.

In my opinion, mean reversion is more predictive for sector indexes than for individual stocks.

My own investing strategy applies mean reversion to the “buy side” for sector funds or sector ETFs and does not utilize short selling. The primary method of this strategy is to buy sectors that have had a short term correction. With this strategy in mind, an investor or investment professional must choose the timeframe and sectors which suit their individual investing style.

Practical Steps

Take the following steps to test the validity of this concept (particularly in those sectors tied to consumer behavior):

  1. Determine the timeframe to measure – daily, weekly or monthly.

  2. Observe gains or losses for the time period measured and observe whether these tend to “change places” from one period to the next.

  3. Do those sectors at the “bottom” tend to move up? Are those at the “top” tending to fall back?

Follow your time of observation by asking this question: Does this pattern suggest a way to improve rate of return and minimize downside market risk?

Ben Reppond is CEO and Investment Manager of Reppond Investments. Reppond Investments, Inc. is a registered investment adviser in the States of Washington and Montana. We may not transact business in any state where we are not appropriately registered, excluded or exempted from registration. Individual responses to persons that involve either the effecting of transactions in securities or the rendering of personalized investment advice for compensation will not be made without registration or exemption.

Investment Advisory Services offered through Reppond Investments, Inc.

Please click on the embedded links for specific details related to sources and comments cited in this article.

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