Simply Put: Sector rotation

Two friends catching up in a coffee shop got into an interesting conversation as one of their favourite musical themes, ‘Wheel of Fortune’ from Pirates of the Caribbean, started playing in the background.

Ram: I struggle to understand the market many a time. . It appears like the deity of fate is spinning the wheel of fortune to randomly select winners and losers in the markets!

Veena: Haha! Why do you say that?

Ram: Well in the last one year, the value of my investments in the Nifty 50 index has remained unchanged. However, my investments in the Nifty IT index are down a painful 25 per cent in the last one year. I had, last year, shifted my investments out of Nifty Auto Index and Nifty Bank, and consolidated into Nifty IT as it appeared there was a digitisation boom playing out and IT stocks were booming. You will not believe it. From the time I shifted from Autos/Banks to IT, the Auto index is up 25 per cent and Nifty Bank is up 8 per cent.

Veena: Hmm…..but the thing is there is no wheel of fortune here and there is a method to the madness. What is happening is sector rotation in the markets.

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Ram: I don’t understand. Can you explain further?

Veena: As economic cycle shifts, investors rotate investments from one sector to another. Economies go through different phases over and over again – expansion, peak, contraction and slump. As these economic phases play out, markets too go through different phases and different sectors outperform in each phase. Investors who are adept at spotting these different phases try to capitalise on them by betting on different sectors according to the phase the economic cycle is entering.

Ram: Hmm ok, but why has IT underperformed?

Veena:   Last year, same time, developed market economies were in a boom as their economies were recovering strongly, supported by ample monetary and fiscal stimulus. This was very positive for IT stocks, which derived most of their revenues from North America and Europe. Since then, the prospects have been changing as high inflation and hawkish central banks dim growth prospects in developed economies. India, with its relatively better macroeconomic fundamentals and good economic recovery in recent quarters, is better-positioned in terms of growth prospects. Thus, there has been some sector rotation, out of export-focussed companies, and towards domestic-focussed companies that will be less impacted by a global slowdown.

So, if you see what has happened here, based on the economic cycle shifting in developed markets, sector rotation has played out in Indian markets. Gradually, as Indian markets also go through economic cycle shifts, as our growth too is correlated to global growth, further sector rotation will happen within our markets.

Ram: Do you have an idea how that will play out?

Veena: Typically, as growth slows, defensive sectors will begin to outperform – sectors like consumer non-discretionary, telecom, pharma, etc. For example, there is this concept called lipstick effect. During times of recessions/economic downturns, people, unable to spend on big or luxury indulgences, spend more on small-ticket and simple items to feel good, like a lipstick. Thus companies/sectors that satisfy small indulgences tend to do well during downturns.

Another interesting thing to note is that there will also be rotation across asset classes according to business cycles. For example, during boom times, debt investors will shift to dividend yield stocks. Dividend yield investors might shift to growth stocks. And reverse will play out in a down cycle.

Ram: Interesting! Thanks for the insights. But still looks like it is not an easy game!

Veena: Of course, not easy. Some mutual funds have launched business cycle funds. Need to see if they are able to get it right

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