Sector rotation based on the business cycle - It can work

 

We are facing business cycle changes with the current slowdown and the policy switch to monetary tightening. Given the rise in inflation, bonds are not the same diversification solution, so other alternatives haver to be reviewed. Sector rotation is a viable alternative, but you need to know where you are at in the business cycle. However, using the concept of macro momentum is a helpful start.

The leading economic indicator index can be used to breakdown the economic environment into four regimes: expansion, slowdown, recession, and recovery. The LEI can be either above or below trend and be either expanding or contracting. If time is divided into these four regimes, market sector performance can be scored to provide conditional returns for different business cycle regimes. See "Sector business cycle analysis" from State Street Global Advisors.  Their research finds clear distinctions across the business cycle. 

In a recession, buy consumer staples, health care, and utilities and sell real estate, technology, and communication services. In a slowdown, hold consumer staples, health care, and industrials, and exit from consumer discretionary, materials, and real estate. The hit rate for excess returns in any month may be between 50-60% for buys but the overall excess performance can be significant.

The real work is forming a portfolio that will be workable and have controlled risk. The variation from portfolio construction may be high; however, the concept of trading against the trends in the business cycle is sound and offer a simple way of playing macro momentum.