Market rotation, sometimes also called sector rotation, is a shift in the pattern of sector outperformance in the stock market. In 2016, for example, the S&P 500 favored defensive sectors over aggressive ones. 2016 produced the opposite result.
The market rotates for two basic reasons:
—change in economic circumstances. In early 2016, for example, Wall Street began to believe that the price of crude oil, which had been in free fall for two years, finally hit bottom at around $26 a barrel. So oil stocks began doing better. Similarly, investors now believe that the election of Donald Trump as president, meaning both houses of Congress and the White House are all Republican, signals the end of Washington dysfunction. This implies a significant turn for the better in the US economy. As a result, the most economically sensitive areas of the stock market have been doing better since Election Day.
—valuation. Professional investors often say that “trees don’t grow to the sky,” meaning that at some point sectors that are enjoying an economic tailwind become too expensive relative to those being buffeted by temporary headwinds. At such times, they will begin to buy stocks in left-behind sectors almost entirely on the idea that as financial instruments they are relative bargains.
short/shallow vs. long/deep
Sector rotations based on valuation tend to be much shorter and shallower than those based on a change in economic circumstances.
the 2015 -16 example
In 2015, the Healthcare sector rose by +5.2% and Energy fell by -23.6%. The difference in performance between the two was a whopping 28.8 percentage points.
In 2016, Healthcare fell by 4.4% and Energy rose by +23.7%. The performance difference between the two was 28.1 points.
what about today?
To me, the extent of the outperformance of the most economically sensitive sectors since the election has been so strong as to invite a market rotation away from them. My guess is that this will be based mostly on relative valuation. If so, the turn away from current market leaders will be relatively brief and the correction in these sectors relatively shallow.
For day traders, this will be a big deal; for you and me, not so much. Our main concern will be the buying opportunity in cyclicals a correction in them will present.