An exciting forecast is doing the rounds among stock market experts: a sector rotation is imminent, i.e. a shift from one sector to another. In plain language: stocks that performed well yesterday, such as technology stocks, will be overtaken by other sector stocks. Read on to find out who could rise and who could fall and how a rotation works.
Specifically, it is assumed that cyclical stocks will be in greater demand in the coming months. In other words, those stocks that have tended to fall sharply in value during the coronavirus crisis. This could mean that technology stocks will be overtaken by industrial and commodity stocks, for example. One possible explanation for this can be found in the “Kitchin cycle”.
The basis for this cycle is provided by the following two figures: the US purchasing managers’ index in the manufacturing sector (ISM Manufacturing) and the yield on a ten-year US government bond, i.e. the interest rate for long-term loans.
These two variables oscillate sinusoidally in the four-year economic cycle, also known as the “Kitchin cycle” (Joseph Kitchin, 1861 – 1932). A high interest rate weakens the economy, causing the purchasing managers’ index, a measure of economic activity, to fall and leading to a parallel fall in interest rates, as demand for credit decreases and inflationary pressure eases.
At some point, usually two years later, the interest rate has fallen to such an extent that it has a stimulating effect again. The economy begins to grow and with it the interest rate drifts upwards until it has a braking effect again.
What the past shows
The economic lows of this rhythm were observed in 2008, 2012, 2016 and most recently in 2020. This rhythm not only determines when share prices reach new highs and when they tend to weaken, but also which sectors should be favored. During the economic upswings from 2012 to 2014 and from 2016 to 2018, cyclical stocks such as Siemens and BASF gained significantly in value.
During the downturns, such as after 2014 or 2018, cyclically insensitive stocks from the consumer goods and pharmaceutical sectors, such as Nestlé or Unilever, shone. These shares are less affected by an economic downturn and benefit from falling interest rates.
In the past, we were able to gain 50 percent twice in each of the last two four-year cycles: in the upswing in BASF shares and in the economic downturn in Nestlé shares.
Incidentally, gold is an investment that is not sensitive to economic cycles. The price of gold has tended to fall during four-year economic upswings, while it has risen significantly during downturns with falling interest rates. The reason for this is obvious: Gold pays no interest. When interest rates fall, gold becomes more attractive. Investors also do not have to fear crises during upswings. During an upswing, everything gets better and the outlook brightens. In the past, financial, debt and other crises have occurred every four years, mainly during downturns, such as the real estate crisis in 2008, the euro crisis in 2012, the China crisis in 2016 and the downturn in 2020, which was exacerbated by Covid-19.
What scenario for the stock market can be derived from the “Kitchin cycle” for the coming months?
Now that we have left the economic trough with the interest rate trough behind us, we should have almost two years of economic recovery ahead of us according to the “Kitchin cycle”. And, as we know, cyclically sensitive stocks such as industrial, commodity and construction companies will benefit particularly from this.
But things are not quite that simple. For the long-term investor, the focus must always be on the specific stock selection, regardless of the sector.
By Thomas Gebert
Member of the Board of Directors of Point Capital Group
Stock market expert and multiple author
5. February 2021
