A sector is a group of stocks in one industry, such as the automobile industry, the oil industry or the consumer goods industry. A group may span different industries but have certain things in common, such as the paying of dividends or company size. Each sector behaves in a predictable way depending on factors in the economy. For example, the housing sector performs poorly when interest rates are high. However, during a recession, when unemployment is high and it is difficult to obtain a loan the housing sector performs poorly even when interest rates are low.
The best way to understand sector potential vs. sector performance is to learn about sector rotation. The Standard & Poor's Guide to Sector Investing, published in 1995, has become a standard reference for the study of sector rotation. It divided the business cycle into five stages: One through three are expansionary stages and stages four and five are recessionary stages. In stage one, exiting the recessionary trough, technology and transportation sectors perform best as the economy gears up to do business. Basic materials, capital goods and services perform best in stage two as the economy expands. During stage three, full economic expansion, consumer staples and energy lead the way as retail consumption and manufacturing reach peak performance. When the economy enters recession in stage four, utilities are a safe, high-yielding investment. In stage five, nearing the economic trough, consumer cyclicals and financials are first to experience the recovery.
If you are able to correctly define when one stage of the business cycle ends and the next begins, using an investment strategy based on sector rotation may result in significant returns. However, accurate identification of sector rotation is difficult, creating a big difference between a sector's potential and its actual performance. Factors such as weather, geopolitics, currency trends and consumer confidence affect sector performance, even if the sector should theoretically be dominant in a particular stage of the business cycle. Sector strategy involves selling stocks that you hold in one sector that have performed best during a cycle and buying those in sectors expected to perform best in the next cycle -- exiting a sector after its initial steep expansion and entering another sector on anticipation of its expansion. The difficulty lies in accurately predicting which sector will actually expand.
In the global economy, even though the automobile sector should show promise during the fifth stage, if the Japanese yen is strong against the U.S. dollar in currency trading, Japanese car companies will sell fewer cars to U.S. consumers. However, if the dollar is weak to the yen because the price of oil is high and Japanese cars get better gas mileage, Japanese car makers will make excellent profits because U.S. consumers will pay high prices for fuel economy.
One way to identify emerging sectors is to maintain moving average price charts that compare one sector against another. The technical indicator known as the price relative is a moving average of prices that trends up when sector stock prices hit higher highs and higher lows. When sector stock prices hit lower lows and lower highs, the price relative trends down. Overlaying price relative charts from different sectors and noting when the trends cross is a good way to identify the beginning of sector rotation.
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