Sector rotation for market timing: theory and practice

Figure 1 shows the classical sector rotation and its relationship to stock market cycle. The theory is simple:

1. In early bull market, the financials, technology, and consumer discretionary are the best performing assets. These assets have been heavily beaten in the preceding bear market and are ready to bounce.

2. In later bull market, when business cycle has turned, industrials, materials, and energy are the best performing assets.

3. In the bear market, investors seek safety in defensive sectors that are not affected by business cycle: Staples, utilities, and health care do well.

Figure 1: Sector rotation and market cycle (theory).

If the above holds, we can use it to time the market. Figure 2 shows historical data. The correlation is not perfect but usable. The bull market in 2003 with Stage I sectors (green) showing strongest performance. Later, Stage II sectors (yellow) took over. In 2007 we had a brief warning with defensive sectors briefly leading (red) but the bull was not yet done. The bottom of bear market in 2009 was market with Stage III sectors leading (red). 

Figure 2: Historical sector rotation and market cycle.

The cycle since 2009 has been more confusing. The cycle started with Stage I sectors leading as expected but subsequently we have had Stage I, II, III sectors alternating. Currently, Stage III sectors are the relative leaders which is not a bullish sign.