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sector rotation

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What do bike racing and a sector-rotation investment strategy have in common? Keith Richards says he's got the answer: They're not for the weak-hearted.

Mr. Richards might know. As a racing cyclist, he trains with a coach, times his carbs and protein before he races and keeps his body-fat ratio low. He is also a portfolio manager at ValueTrend Wealth Management in Barrie, Ont., who uses active investment management by tracking market sector patterns and using them as a guide for buying and selling investments.

"You could use some sort of buy-and-hold strategy, and over time you'll make some money," he explains. "But if you want to outperform the market significantly, you have to have someone like me who's more active, or do it yourself.

"And yes, just like the athlete, it's going to require greater effort."

It sounds a bit like a knock on slow-and-steady investing. But some investors and advisers have been swearing by sector rotation for decades, claiming this tactical approach works.

In a nutshell, sector rotation requires moving money from one industry sector to another in order to beat the market.

For instance, if you think the financial sector is about to take a nosedive, but utilities are ready to swing up, you would shift part of your portfolio and become overweight on utilities. The trick is to anticipate these swings before everyone else catches on.

But how is anyone expected to know how sectors will move tomorrow, next week or even next year?

Part of that quandary can be addressed by understanding the nature of economic cycles and how they affect specific sectors of the stock market. In short, stocks don't all act alike.

Historically, riskier sectors tend to outperform the market when times are bullish, and underperform when they are tougher. This makes sense – when the economy is booming, people feel more optimistic and buy discretionary items causing those sectors to boom. But when a recession hits, investors move their money to "safer" areas such as consumer staples or utilities.

Take what happened during the tech boom and bust in 2000. While the tech sector in the United States posted significant losses, utilities, consumer staples, financials and energy made gains. People moved their money.

To act ahead of the curve, however, you need to picture the market cycle like a roller coaster, says Bill Carrigan, a technical analyst at Getting Technical Information Services in Vineland, Ont.

In the front cars you'll find financial, utilities and consumer sectors. Because they are interest-rate sensitive, "they lead the markets at peaks and troughs," he explains. Telecommunications, health care, technology and industrials ride in the middle cars, while energy, metals, mining and materials ride in the back.

In a bull market, the front cars are leading until they reach the top and start falling over the crest. It takes some time for the final cars to reach that drop, too – anywhere from 18 to 24 months, says Mr. Carrigan. Those who employ sector rotation look for indications that their cars are about to go over the edge and it's time to move their money to those making the next climb.

It's not always this simple, of course. When the entire market collapses, like in 2008 and 2009, the rebound bull involved all sectors. "It didn't matter what you owned, it went up," he says. "So there's not much sector rotation there because everything got blown down and everything got blown back up again."

These situational outliers are exactly why Pat McKeough, a portfolio manager and stock analyst in Toronto, is not convinced stock rotation is a great strategy.

"You can have some extraordinary wins if you get in the golds at the right moment, or you sell the techs at the right moment. But nobody can do that consistently," he says. "If you could, you'd make all the money in the world."

The problem is that the market can be a random beast at times. A market index may drop to, say, 1,500 from 2,000, and this may be enough to make you think it's time to invest while it's low. "Then it rises to 1,600, and you think now it's going back up to 2,000, so you invest further. Instead, it turns around and plunges to 1,000," Mr. McKeough says.

His advice? Focus on well-established companies and diversification. "You're basically asking too much of yourself to know when you can get in and out of the right sectors at the right time."

Mr. McKeough says investors have to get two things right to make sector rotation work: the top sectors, and the top stocks in those sectors.

Yet with today's exchange-traded funds (ETFs), which track all markets in Canada with the exception of telecoms, choosing specific stocks is no longer an issue. Investors can easily zoom in on any sector.

Mr. Carrigan recommends thinking of sector rotation as less of a way to time the market and more as a way to rebalance a portfolio during swings. It's about staying fully invested, he says.

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