Blog - Investing Notes

July 10, 2007 - Perfect Sector Rotation

Is the conventional wisdom that stocks of different sectors outperform systematically during different phases of the business cycle correct, and exploitable? In their July 2007 paper entitled "Sector Rotation over Business-Cycles", Jeffrey Stangl, Ben Jacobsen and Nuttawat Visaltanachoti test a sector rotation strategy that times U.S. sector stock holdings over U.S. business cycles, as defined by the National Bureau for Economic Research (NBER). The conventional sector outperformance wisdom they evaluate comes from Standard & Poor's Guide to Sector Investing 1995. Using monthly industry returns, market returns and Treasury bill rates for 1948-2006 (nine complete business cycles), they find that:

• Industry returns exhibit the same general pattern as market averages, lowest during business cycle Stage IV and highest during Stage V. Actual industry performance based on nominal returns across business cycle stages partially confirms conventional wisdom. (See the business cycle model and table of industries-sectors below.)
• A sector rotation strategy based on conventional wisdom and perfect hindsight for timing stages of the business cycle produces a marginal 2.1% annual Jensen’s alpha. This hypothetical outperformance would likely not survive exclusion of hindsight and inclusion of transaction fees.
• The performance of sector rotation is inconsistent across the business cycle. During early and middle expansion (Stages I and II) "favored" sectors underperform the market, with negative Jensen's alphas of -5.3% and -1.0%, respectively. During early recession (Stage IV), sector rotation strongly outperforms, with a Jensen’s alpha of 10.3%.
• An alternative, much simpler market timing strategy that is fully invested in the broad market during Stages I, II, III and V and in cash during Stage IV hypothetically beats a sector rotation strategy over the same period in terms of cumulative wealth and Sharpe ratio. (See last chart below.)

The following figure, taken from the paper, is an idealized NBER-style business cycle divided into five stages as done in other studies. Expansions span trough to peak in Stages I-III; recessions, peak to trough in Stages IV-V. As indicated, expansions are typically much longer than recessions.

The following table, also from the paper, summarizes the conventional wisdom (based on Standard & Poor's Guide to Sector Investing 1995) relative outperformance of sectors by stage of the business cycle.

The next figure, again from the paper, shows cumulative wealth from an initial investment of one dollar over the period 1948-2006 for: (1) a "Market" strategy that holds the market portfolio for the entire period; (2) a "Sector Rotation" hypothetical (perfect hindsight) strategy that holds sector portfolios in equal weights during the business cycle stage in which conventional wisdom says they are optimal; and, (3) a "Market Timing" hypothetical (perfect hindsight) strategy that holds the market portfolio during business cycle Stages I, II, III and V and cash during Stage IV. It shows that the simpler "Market Timing" hypothetical strategy has greater potential than "Sector Rotation." It also shows that both hypothetical timing strategies would beat buy-and-hold for an investor/trader who can accurately anticipate business cycle phases.

The authors note that NBER tracks only business cycle turning points (peaks and troughs), not the five phases defined above, and NBER can take as long as two years after a turning point to designate its date. They also note that one business cycle can be very different from another.

In summary, realistic assumptions about business cycle predictability make it unlikely that an investor/trader can outperform the broad stock market using a sector rotation strategy. Moreover, an arguably easier-to-time flight to cash during the first half of recessions offers greater potential.

For related research, see our Blog Synthesis: The Economy and the Stock Market.