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Narrator: The economic cycle is when the economy moves from growth to recession and back to growth again. It's one of the most influential forces in the stock market.
The economic cycle is significant because it plays a large role in determining corporate profits, which are probably the most important factor that influences stock prices.
Where things get complicated is how the economic cycle impacts different sectors.
Stock market sectors are sensitive to different stages of the economic cycle.
Simply put, some sectors may outperform when the economy is growing, while others may outperform when the economy is in a recession.
The varying performance is something that investors refer to as sector rotation. Sector rotation is driven by investors buying and selling different stocks during the economic cycle's stages of growth and recession.
Let's look at an example of how sectors typically perform throughout the economic cycle.
Let's suppose that the economy is emerging from a recession. One of the first sectors that investors usually move, or rotate, into is financials, which includes businesses like banks, brokers, and insurance companies. Why?
Toward the tail end of a recession, interest rates are unusually favorable for businesses such as banks. Consequently, investors rotate into the financial sector when they anticipate a recovery.
After the economic cycle turns up, investors usually next rotate into the technology sector.
This sector is sensitive early in the economic cycle because businesses invest in new technology to make productivity gains.
As the economic recovery gathers momentum, investors typically move into the consumer discretionary sector.
This includes businesses like automobiles, housing, and retail—things that are discretionary, or nonessential.
Consumers typically grow more confident as the economic recovery takes hold. And with the growing confidence can come increased spending on discretionary items.
After consumer discretionary, investors generally rotate into the industrials and basic materials sectors.
This is usually considered the midpoint of the growth stage, which is when these types of businesses increase production in response to increasing demand.
As the growth stage matures, investors typically rotate into the energy sector. At this point in the cycle, the energy sector benefits from increased demand for transporting goods during the previous stage of the cycle.
When the economy transitions from growth to recession, investors may get defensive and start to rotate into the sectors that are less sensitive to the economic cycle. These sectors are sometimes referred to as defensive sectors because they can offer relative protection during a recession.
When considering defensive sectors, think about it this way: What are the goods and services that you'd keep buying even in a recession?
Most likely you'd continue spending on things like food, utilities, and your health, to name a few. These are typical examples of goods and services supplied by companies in defensive sectors. The first sector investors usually rotate into during a recession is consumer staples.
This sector includes companies that make food, beverages, and household items.
People still need to eat, drink, and clean their houses during an economic downturn, which is why investors rotate into consumer staples in the early stages of a recession.
As a recession continues, investors typically rotate into the utilities sector next because gas, electric, and water bills also have to be paid during an economic downturn.
When a recession worsens, investors might move into the health care sector because people are obviously willing to pay for health care no matter what the economy is doing.
Toward the tail end of the recession, investors generally rotate into the services sector. This sector includes waste management and labor staffing.
After rotating into services, the economic cycle usually starts over again, and the investors might rotate back into financials in anticipation of growth and the end of the recession.
So how can you identify the sectors that are rotating in and out of favor under the ideal circumstances that we've covered? You can start by watching price trends among the different sectors.
If an economic recovery is well underway, look for new upward trends to emerge in the industrials and basic materials sectors.
Conversely, in the middle of a recession, look for new upward trends in sectors like utilities and health care.
On-screen text: Disclosure: For illustrative purposes only. Not a recommendation.
Narrator: Being aware of sector rotations can help active investors adjust their portfolios. And although there may be indications of a sector coming in to or moving out of favor, remember that it's difficult to predict with certainty and try to look for confirmation when possible.
For example, if an active investor observes that a sector might be coming in to favor, she might hold existing investments in the sector or look for new opportunities in that sector.
On the flip side, if she observes a sector seems to be going out of favor, she might raise stop losses or sell holdings within that sector to cut losses or lock in profits.
Applying sector rotation in these ways can help investors manage a portfolio and even present new opportunities. But sector rotation takes some time and experience to learn.
It's a good idea to go through at least one economic cycle and observe how investors rotate from one sector to the next at each stage of the cycle before making your own decisions based on sector rotation.
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