A key to weathering – and potentially profiting from – a market correction is planning and implementation.
Track the Economic Cycle with Sector Rotation
Some traders have long sought to capitalize on the economic cycle as part of their investing strategies. One common technique, sector rotation, is pretty straightforward: Invest in industries (or business sectors) that tend to do well in certain economic conditions. Depending on whether the economy is expanding or contracting, traders will rotate to other sectors accordingly.
“Basically, having a strong grasp of the economic cycle should help a trader’s perception of optimal market sectors,” said Brian Bachelier, vice president of active trader strategy at Scottrade.
The S&P 500 is comprised of 10 to 12 different sectors (not all financial experts classify sectors in the same way) that are also subdivided into smaller industry groups. At its simplest level, sector rotation trading strategies assume that certain sectors of the market should perform better at specific phases of the economic cycle.
For example, expansion tends to benefit companies directly tied to cyclical growth. This could include firms operating in the construction, energy and technology sectors. During contraction in the economic cycle, traders look for relative stability in core services such as health care, utilities and transportation.
In theory, aligning your portfolio with the right sectors and groups can boost returns – or minimize losses. Conversely, being out of sync with the economic cycle could mean missing out on the momentum from higher-performing sectors.
Using Screening Tools
Knowing your risk appetite is always important, but particularly for a plan that inherently relies on market timing and over-allocation in specific sectors. While the time and money required to manage individual securities can be daunting to retail traders, Scottrade offers screening tools to help simplify your strategy.
Through sector-based mutual funds and exchange-traded funds (ETFs), you can focus your portfolio on specific economic activity. Granted, you’re sacrificing some optimization, but you gain sector diversification with a single security and help limit the risk of holding the wrong company in the right sector.
Interest Rate Consideration
In recent years, lower interest rates have provided some challenges to the traditional norms of sector rotation. Some investors today are rotating into sectors that pay higher dividends than what they can get either from bonds or from other dividends in other sectors. And they’re staying in those sectors.
The allure of higher dividends has prolonged outperformance in some sectors, making it difficult to use historical economic data as a precedent for rotating into or out of other sectors. Shifting to a defensive portfolio of consumer staples, for example, was once viewed as a signal for the market at its height. Lately though, the attractive and rising dividends associated with those stocks have extended their presence in many trading portfolios.
“Evaluating the economic cycle is always a difficult task, but, ideally, you want to view where the cycle has been and where it’s going,” Bachelier said. “From there, the key is to understand how sector fits into your overall trading plan.”
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Diversification may help spread risk, but it does not assure a profit, or protect against loss, in a down market.
Screener results are returned based upon previous market close values.
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