what it is
“Rotation” is the term the stock market uses to describe the process of shifting portfolio holdings from one group of stocks to another in search of higher potential returns.
rotation patterns
There are a number of drivers that influence the rotation process:
—the business cycle, which is probably the most important and far-reaching. In its simplest form, the idea is that national central banks attempt to create maximum sustainable GDP growth by using short-term interest rates to either accelerate the rate of growth by lowering the Fed Funds (short-term) interest rate or to retard too rapid growth by raising it. Professional investors typically shift their holdings in accord with, or in anticipation of, central bank actions–to emphasize sectors and individual stocks that benefit from consumer spending as they perceive that rates are about to fall, and into defensive sectors like utilities or consumer staples when they conclude that rates are about to rise.
—an industry-specific wave. One of my early mentors once explained his investment process like this:
let’s assume the government announces a national road-building program. Some people will buy the road construction stocks, others will buy the cement plants. I buy the makers of cement trucks. His idea was that if there are only one or two companies in the country that make cement trucks, both are sure to benefit. Trucks are also far enough back in the chain of beneficiaries that their stock prices are unlikely to have risen already to reflect the upcoming surge in orders. It’s also possible that not that many people are thinking that far ahead, so that the positive surprise will be BIG when the company begins to report accelerating earnings gains. And, again because cement truck sales aren’t typically glamorous, and therefore front of mind, the stocks are likely to be very cheap.
There’s at least one other way to approach this, though. You start by buying construction companies, then shift (rotate) into cement plants as construction company stocks begin to get pricey …and when plants move up, only then into trucks. This is rotation.
An important note: when the market gets to the point of bidding up cement truck makers, we’ve reached pretty much the end of the line. One of two things will happen: either the market will return to the original, most obvious beneficiaries, the construction stocks, and start another round of bidding prices up or, just as likely, the party’s over and the market moves on to other areas. Either way, this is another important feature of rotation patterns. They should force us to think about how much more outperformance is left in the stocks we hold. My rule has been that the tinier, niche-ier, funkier the stocks I’m holding are, the closer the end of the movement is.
the main classic rotation today: AI hardware
Over the past year or so, AI hardware relative performance has followed the typical rotational pattern:
—–first, Nvidia, the pure play on AI chips,
—–then to Broadcom et al, who build AI installations that use AI chips,
—–then to Micron, Samsung Electronics and Hynix, which make DRAM that are adjuncts to AI chips, and
—–now to Credo, Wolfspeed (yes, it was recently in Chaper 11, but I like the name), Cerebras and other lesser-known firms, that make doodads that do things like control the heat in AI centers. I see these as the AI equivalent of the cement trucks. The current dilemma for early-in, early-out investors, I think, is that although they might like to rotate away from tech into something else, there’s no other obvious place to go in the US market.
I sold my NVDA, which I’d held for several years, last summer, because its operating leverage was disappearing, and rolled into the other names in the order above. I bought NVDA back recently on the idea that it’s now morphed itself into being a closed-end investment company, and provides low-beta exposure to the overall industry.
other kinds of rotation
–in my first full-time portfolio manager job, my office was right next to the firm’s most successful portfolio manager. The organization set conservative goals for us–bonuses maxed out at outperforming the benchmark index by 1 percentage point, and disappeared entirely if the portfolio didn’t at least match the index. My colleague typically broke through the 1% target before midyear. As soon as he did so, he “derisked” his portfolio by making it look just like the index and basically coasted for the rest of the year. The following January, he’d reset. Another, though infrequently used, reason for portfolio rotation.
–home market vs. foreign stocks. There were several seismic events in the world during the closing decades of the last century: the revaluation of the Japanese yen, which caused a massive surge in domestic-oriented stocks; China declining to renew the UK lease of Hong Kong, which refocused world attention to mainland stocks; and the formation of the euro, which triggered a huge M&A wave in anticipation of the Common Market.
Since the turn of the century, however, world equity attention has focused almost exclusively on the US, with domestic portfolio managers having no reason not to stay at home. The current administration’s economic plan, however, has revived interest in EAFE stocks, which since the inauguration and until relatively recently have steadily outperformed the S&P 500, despite AI being the largest single area the S&P is exposed to.