When the Market Is Volatile, Look For Sector Rotation

By: Wayne Duggan

On the surface, volatility is scary. Everywhere you look it seems like stocks have dropped the last month.

But traders who are watching the sell-off closely have seen that not all sectors of the market have been hit equally. In fact, there are some sectors that have gained ground since the end of September. Here’s a look at sector rotation in the stock market and why losses in certain sectors have resulted in gains in others.

What Is Sector Rotation?

While stock prices are driven on some level by fundamental performance, the fact that the S&P 500’s overall price-to-earnings ratio, price-to-sales ratio and other fundamental metrics fluctuate over time is an indication that investor sentiment also plays a key role in stock prices. When investors feel confident about the economy, they are willing to take on more risk in the market and pay higher prices for that risk.

The media often refers to periods in which investor confidence is high as the “risk-on” trade in the market. Traders have high risk tolerance during these periods and are willing to abandon safer plays in favor of stocks with more potential upside.

When investor sentiment turns negative, however, “risk-off” traders tend to dump their riskier bets and rotate their money into safer sectors and stocks. As a result, these “risk-off” plays tend to perform well during times of market turmoil, a phenomenon that may seem counterintuitive unless you understand the basics of sector rotation.

Risk-On Sectors

The “risk-on” sectors can change depending on exactly where the anxiety in the market is coming from. The recent dip in the market has been triggered by fears about tech stocks, particularly the popular FANG stocks – Facebook ($FB), Amazon ($AMZN), Netflix ($NFLX) , and Google ($GOOGL) (Alphabet).

The two worst-performing SPDR sector ETFs since October 1 have been the Communications Services Select Sector SPDR Fund ($XLC) and the Technology Select Sector SPDR Fund ($XLK), which are down 11.8 percent and 10.8 percent, respectively. It’s no surprise that Facebook and Alphabet are the two largest holdings in the XLC and tech giants Apple ($AAPL) and Microsoft Corporation ($MSFT) are the two largest holdings in the XLK.

Risk-Off Sectors

At the same time, the Utilities Select Sector SPDR Fund ($XLU) and the Consumer Staples Select Sector SPDR Fund ($XLP) have been immune to the recent sell-off and are up 1.0 percent and 0.1 percent since October 1, respectively. Utilities and consumer staples companies provide products and services that people always need and are not subject to large cyclical economic swings. Therefore, these stocks are considered “risk-off” investments.

Examples of utility stocks include top XLU holdings NextEra Energy ($NEE) and Duke Energy ($DUK). Risk-off consumer staples stocks include Procter & Gamble ($PG) and Coca-Cola ($KO).

Sector rotation is a fundamental aspect of the stock market. Except in the most extreme circumstances, most institutional managers aren’t exiting the market entirely during bouts of volatility. So, if one sector is exceptionally weak, that money could potentially be invested somewhere else. This is why investors should look to rotate out of higher-risk tech stocks and into these risk-off sectors.

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Disclosure: the author holds no positions in the stocks mentioned.

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