Sector Rotation and Where Money Hides

An index can be flat for weeks while a great deal is happening underneath it. Money leaves one group of companies and enters another, and the index, which sums them all, barely moves. This movement is called sector rotation, and it is one of the best windows into what the market thinks is coming.

The sectors

Shares are grouped by what the companies do: technology, financials, energy, healthcare, consumer staples, consumer discretionary, industrials, utilities, materials, real estate and communications. Each group responds differently to growth, inflation and interest rates. Utilities and staples are defensive: their earnings change little with the economy. Technology and discretionary are growth-sensitive. Energy and materials follow commodity prices. Financials respond to the yield curve.

The rotation pattern

Over an economic cycle, leadership tends to pass from group to group. Early in a recovery, financials and discretionary lead. In the middle, technology and industrials. Late in an expansion, energy and materials. In a slowdown, utilities, staples and healthcare. The sequence is not exact, but it repeats often enough that the current leaders hint at the stage of the cycle.

Why index traders care

• Leadership tells you how durable an index move is. A rally led by defensive sectors is a cautious rally; one led by technology and discretionary has conviction behind it.
• Rotation into defensives while the index holds its highs is a classic warning that the index may follow.
• A technology-heavy index and a blue chip index diverge during rotation, and the divergence is tradeable for those who follow both.

Reading it

Compare the performance of two or three sectors against the index over a month. Defensives outperforming while the index rises is a sign of hidden caution. Growth sectors outperforming while the index falls is a sign of hidden strength. Equal-weight versions of an index, which give every company the same influence, show rotation more clearly than size-weighted versions dominated by a few names.

Rotation is context, not a trigger. It tells you which index to favour, how much conviction to have in a breakout, and when to be sceptical of a new high. A new high in the index made with defensive leadership deserves a smaller position than one made with cyclical leadership.

What to watch

Watch the relative performance of defensive and growth sectors against the index, the behaviour of the equal-weight index against the size-weighted one, and the moment leadership changes. Those moments often come before the index itself turns.