Business Cycle and Sector Rotation

In 1860, Clément Juglar, a French physician and statistician, developed a method known as Juglar Cycles to understand the cyclical nature of economic activities. He was the first to identify economic cycles and used a periodicity of approximately 8 to 11 years to identify three economic cycle stages – prosperity, crisis, and liquidation[1]Guitton, Henri. “Business cycle.” Encyclopedia Britannica, 3 Oct. 2018, Accessed 20 October 2021.. Since then, there have been many different approaches to comprehend the regularly recurring business and economic fluctuations, including the Kondratiev wave, the Kitchin Cycle, the Kuznets Swing, etc.

In 1913, Wesley Clair Micthell, a University of Columbia Economics Professor, presented “an analytic description of the complicated processes by which seasons of business prosperity, crisis, depression, and revival come about in the modern world” in his book Business Cycles. Three decades later, Mitchell collaborated with Arthur Burns, a future Federal Reserve Chair, and refined the concept of Business Cycles in, Measuring Business Cycles.

A business cycle is a series of events that occurs with some repetitive frequency, like a wave. Burns and Micthell named four stages of a complete business cycle: peak, trough, expansion, and contraction. National Business of Economic Research (NBER), the official keeper of information on economic cycles, follows two official phases of a complete economic cycle: expansion or economic recovery and contraction or recession. The NBER’s Business Cycle Dating Committee identifies the turning points within a cycle and reports them a few months after their occurrence. (Note: in the rest of this article, we will use the terms economic cycles and business cycles interchangeably)

Business Cycle and Sector Investing

During expansion, demand increases, sentiments improve, employment increases, and business activities expand. In the contractionary stage, demand shrinks, sentiments worsen, unemployment rises, inflation climbs, and business activities contract. When the economy gets too hot, leading to high inflation or too cold, leading to high unemployment, the central banks tweak monetary policies to impact demand/supply, maintain price stability, and sustain full employment.

Fig. 1: Sector Rotation Within An Economic Cycle

The shifting economic cycles and monetary policies affect various industries differently. Most major sectors of the economy expand in an expansion and contract in a recession. To better understand the behavior of industries during expansions and contractions, market analysts use five phases of a complete economic cycle – early expansion, middle expansion, late expansion, early contraction, and late contraction.

In Standard & Poor’s Sector Investing, Sam Stovall tied industry sectors’ performance to economic cycles. He wrote, “stock prices usually follow a similar, though anticipating pattern by rising about five months prior to when the economy expands and falling about seven months before the economy begins to contract.” He further notes that some industries outperform the overall stock market during certain phases of the economic cycle and underperform during other stages.

He analyzed the performance of over 90 industries grouped under 11 sectors over several complete business cycles. He then listed the industry sectors that usually outperform during certain cycle phases (see Fig. 1).

Market Cycles and Business Cycles

Fig. 2: Sector Rotation and Market Cycles

In Intermarket Analysis, John Murphy maps market cycles to business cycles and industry sectors (see Fig. 2). Unlike Stovall, Murphy uses four business cycle phases – full recession, early recovery, full recovery, and early recession. The relationship between Murphy’s and Stovall’s cycle phases is quite intuitive.

The four market cycle stages are market bottom, bull market, market top, and bear market. The market bottom falls between early recession and full recession, the bull market happens between full recession and early recovery, the market top arises between early recovery and full recovery, and the bear market occurs between full recovery and early recession.

Underlying the business cycles and the performance of the companies are economic and fundamental factors. Murphy uses four factors – consumer expectations, industrial production, the direction of interest rates, and the slope of the yield curve – for Intermarket analysis. The table below shows how these factors behave when the economy goes through different stages of its cycle.

Full Recession Early Recovery Full Recovery Early Recession
Consumer Expectations Reviving Rising Declining Falling Sharply
Industrial Production Bottoming Rising Flat Falling
Interest Rates Falling Bottoming Rising Peaking
Yield Curve Normal Steep Flattening Inverted

Intermarket Analysis and Business Cycles

The traditional approach to equity investing analyzed the securities and the stock market in isolation. An alternative approach is to use the Intermarket Analysis for more insights. The Intermarket Analysis is predicated on the phenomenon that global asset markets consistently influence each other. Murphy’s Intermarket Analysis delves deeper into the correlations between various asset markets, namely equity, bonds, commodity, and the dollar or currency market.

The rising interest rates are ordinarily bad for equities, especially for the interest rate-sensitive sectors. Rising commodity prices are generally due to rising inflation, which puts upward pressure on interest rates. The falling dollar typically boosts commodity prices. Murphy notes that the dollar and commodities usually trend in opposite directions. The same is true with bonds and commodities. However, bonds and stocks frequently trend in the same direction, with bonds peaking and bottoming ahead of stocks. He concludes that the bonds usually peak midway through an economic expansion or a bull market and trough about midway through a contraction or a bear market.

Another of his observation is the effect of the commodity/bond ratio on the equity market. A rising ratio, i.e., commodities are outperforming bonds, favors inflation-type stocks, a group that typically includes gold, energy, and basic materials. A falling ratio favors interest-rate-sensitive stocks, including consumer staples, drugs, financials, and utilities.

Martin J. Pring mapped the Intermarket Analysis onto the business cycle using a six-stage business cycle model (see Fig. 3). Stage 1 begins when the economy gets into a recession, and Stage 6 ends when the economic expansion is about to end. To summarize Pring’s conclusions:

  • Stage 1: Bonds turn up  – stocks and commodities continue to fall
  • Stage 2: Stocks turn up – bonds keep rising, and commodities keep falling
  • Stage 3: Commodities turn up – bonds and stock continue to rise
  • Stage 4: Bonds turn down – stocks and commodities keep rising
  • Stage 5: Stocks turn down – commodities rising, bonds falling
  • Stage 6: Commodities turn down – all three markets keep falling

Sector Rotation

A sector rotation strategy uses the idea that different sectors show relative strength during certain business cycle phases. Many academic papers have examined the usefulness and applicability of various sector rotation strategies in the stock market. Some came away with favorable conclusions, and some did not. They all, however, conclude that different sectors perform differently during certain business cycle stages. They differ in the efficacy of various sector-rotation strategies.

Stangl, Jacobsen, and Visaltanachoti (2009)[2]Jacobsen, Ben and Stangl, Jeffrey Scott and Visaltanachoti, Nuttawat, Sector Rotation Across the Business Cycle (December 2009). Available at SSRN: … Continue reading found that sector rotation generated 2.3% annual outperformance from 1948 to 2007. The authors used Jensen’s Alpha, a risk-adjusted return over or below that predicted by the Capital Asset Pricing Model (CAPM), to compute outperformance. They say that this performance quickly dissipates without the benefit of hindsight and after a reasonable allowance for transaction costs. They used NBER’s Business Dating chronology for sector rotation.

Sasseti and Tani (2003)[3]Tani, Massimiliano, Dynamic Asset Allocation Using Systematic Sector Rotation (December 1, 2003). Available at SSRN: or analyzed simple market timing techniques on 41 Fidelity Select Sector funds and concluded that each method consistently outperformed the buy-and-hold strategy. For timing, the author used relative strength based upon three different indicators, namely:

  1. The Rate of Change calculated for each fund in the previous 30, 60, and 90 days
  2. The Alpha of CAPM calculated for each fund using the same time frame
  3. Relative Strenght of each fund with respect to the S&P 500 using  MACD (Moving Average Convergence Divergence) calculated over the previous 30, 60, and 90 days

Sasseti and Tani believe that a significant portion of the outperformance comes from the ‘systematic’ side of the strategy (something that Stangl, Jacobsen, and Visaltanachoti study did not use) and not the sole ‘sector’ component.

Gayed (2014)[4]Gayed, Michael, An Intermarket Approach to Beta Rotation: The Strategy, Signal, and Power of Utilities (January 31, 2014). 2014 Charles H. Dow Award Winner Updated Through October 31, 2020, Available … Continue reading used defensive beta rotation to generate excess returns, specifically, “When a price ratio (or the relative strength) of the Utilities sector to the broad market is positive over the prior 4-week period, position into Utilities for the following week. When a price ratio (or the relative strength) of the Utilities sector to the broad market is negative over the prior 4-week period, position into the broad market for the following week.” Their finding was that the signaling power of the Utilities sector has persisted over time and can be profitably exploited. However, this strategy does not differentiate between sectors but uses only two – Utilities and the broad market.

Faber (2010)[5]Faber, Meb, Relative Strength Strategies for Investing (April 1, 2010). Available at SSRN: or employed simple quantitative methods based upon momentum to improve risk-adjusted returns. Faber uses ten sectors – Consumer Non-Durables, Consumer Durables, Manufacturing, Energy, Technology, Telecommunications, Shops (Wholesale, Retail, etc.), Health, Utilities, and Other (Mines, Construction, Transportations, etc.). His system ranks these sectors monthly based upon the previous month’s total return, including dividends, and then invests in the top ‘X’ sectors. The X could be 1 or 2 or more. If a sector falls off the top X, then the system disinvests from it. Faber concludes that such a strategy improved the absolute returns across various measurement periods over the past eight decades. However, the volatility and drawdown remained high.

Sector Investing – In-Favor/Out-of-Favor Rotation

Many studies and market participants have proven that the sector rotation strategies provide meaningful market outperformance. However, implementing it is easier said than done. The biggest challenge is forecasting the turning points in an economic cycle or identifying various cycle stages. The official report from NBER’s Business Dating Committee comes months after the turn in the cycle. Trying to identify cycle stages by monitoring economic and fundamental indicators is also fraught with challenges due to the noisiness of data.

Another challenge is that the stock market is frequently the leading indicator. It starts to rise months before the beginning of the economic expansion and starts to fall months before the contraction begins. This correlation means that we need to forecast the cycle phases much before their occurrence, which is even less reliable.

A better approach would be to select in-favor/out-of-favor sectors based upon their relative performance. The Business Cycle and Intermarket Analysis study establishes that various industries and asset classes perform better during certain cycle phases. Figuring out leading or lagging sectors at any given time is more straightforward than identifying specific economic cycle stages.

The stock market is a Discounting Mechanism, which means that the stock market has discounted, or taken into consideration, all available information, including present and potential future events. All unexpected developments are quickly discounted, and the prices promptly reflect their impact. This trait greatly helps in pinpointing the business cycle stages. In any case, we would be better off by following the prices of sectors that we want to invest in than by trying to forecast the various cycle stages for sector rotation.

Relative Strength

Fig. 4: Relative Strength of Commodities and Bonds

Relative strength methods are pretty helpful in identifying the outperforming and underperforming sectors. Relative strength is a momentum investing technique that uses technical analysis to compare two or more securities and pick out leaders and laggards.

A simple relative strength technique is the ratio of prices of two securities. If the slope of such a ratio is ascending, the numerator leads the denominator and vice versa. On the chart of this ratio, we can then use any trend-following or trend-reversal strategy to determine when to rotate from one sector to another. Fig. 4 shows that for the better part of the period from May 2018 to April 2020, the commodity/bond ratio ($CRB/$USB) was falling, which meant that bonds outperformed commodities during that time. The ratio turned around in April 2020 and started to rise. Using the MACD, we can pinpoint the trend reversal sometime in May 2020, which was an excellent time to be in the sectors that benefit from rising commodities, including industrials, energy, basic materials, etc.

In Conclusion

The economy goes through a series of cyclical phases – peak, contraction, trough, and expansion – over several years. Some business sectors perform better during certain stages of an economic cycle and some during others. To take advantage of these regularly occurring business and economic fluctuations, we need to know when a sector typically outperforms and when it underperforms.

The Business Cycle model provides a mechanism to identify the phase during which an industrial sector has a greater probability of outperforming the market. The sector rotation approach guides us in taking money out of underperforming sectors and putting it into outperforming sectors.

However, this is not so easy as the dating of the economic cycle occurs months after the event and is not very helpful in making stock market decisions. Intermarket Analysis and relative strength comparison offer better methods for pinpointing the time for such rotation between in-favor and out-of-favor sectors.

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1 Guitton, Henri. “Business cycle.” Encyclopedia Britannica, 3 Oct. 2018, Accessed 20 October 2021.
2 Jacobsen, Ben and Stangl, Jeffrey Scott and Visaltanachoti, Nuttawat, Sector Rotation Across the Business Cycle (December 2009). Available at SSRN: or
3 Tani, Massimiliano, Dynamic Asset Allocation Using Systematic Sector Rotation (December 1, 2003). Available at SSRN: or
4 Gayed, Michael, An Intermarket Approach to Beta Rotation: The Strategy, Signal, and Power of Utilities (January 31, 2014). 2014 Charles H. Dow Award Winner Updated Through October 31, 2020, Available at SSRN: or
5 Faber, Meb, Relative Strength Strategies for Investing (April 1, 2010). Available at SSRN: or