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Sector Rotation & Stocks to Watch During a Recession or Recovery - YouTube
Channel: TD Ameritrade
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The economic cycle is when the economy moves
from growth to recession and back to growth
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again.
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It's one of the most influential forces
in the stock market.
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The economic cycle is significant because
it plays a large role in determining corporate
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profits, which are probably the most important
factor that influences stock prices.
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Where things get complicated is how the economic
cycle impacts different sectors.
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Stock market sectors are sensitive to different
stages of the economic cycle.
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Simply put, some sectors may outperform when
the economy is growing, while others may outperform
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when the economy is in a recession.
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The varying performance is something that
investors refer to as sector rotation.
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Sector rotation is driven by investors buying
and selling different stocks during the economic
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cycle's stages of growth and recession.
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Let's look at an example of how sectors
typically perform throughout the economic
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cycle.
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Let's suppose that the economy is emerging
from a recession.
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One of the first sectors that investors usually
move, or rotate, into is Financials, which
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includes businesses like banks, brokers, and
insurance companies.
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Why?
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Toward the tail end of a recession, interest
rates are usually favorable for businesses
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such as banks.
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Consequently, investors rotate into the Financial
sector when they anticipate a recovery.
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After the economic cycle turns up, investors
usually next rotate into the Technology sector.
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This sector is sensitive early in the economic
cycle because businesses invest in new technology
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to make productivity gains.
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As the economic recovery gathers momentum,
investors typically move into the Consumer
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Cyclical sector.
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This includes businesses like automobiles,
housing, and retail鈥攖hings that are discretionary,
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or nonessential.
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Consumers typically grow more confident as
the economic recovery takes hold.
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And with the growing confidence can come increased
spending on discretionary items.
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After Consumer Cyclical, investors generally
rotate into the Transportation, Industrials,
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and Basic Materials sectors.
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This is usually considered the midpoint of
the growth stage, which is when these types
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of businesses increase production in response
to increasing demand.
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As the growth stage matures, investors typically
rotate into the Energy sector.
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At this point in the cycle, the Energy sector
benefits from increased demand for transporting
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goods during the previous stage of the cycle.
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When the economy transitions from growth to
recession, investors may get defensive and
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start to rotate into the sectors that are
less sensitive to the economic cycle.
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These sectors are sometimes referred to as
defensive sectors because they can offer relative
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protection during a recession.
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When considering defensive sectors, think
about it this way: What are the goods and
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services that you'd keep buying even in
a recession?
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Most likely you'd continue spending on things
like food, utilities, and your health, to
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name a few.
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These are typical examples of goods and services
supplied by companies in defensive sectors.
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The first sector investors usually rotate
into during a recession is Consumer Staples.
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This sector includes companies that make food,
beverages, and household items.
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People still need to eat, drink, and clean
their houses during an economic downturn,
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which is why investors rotate into Consumer
Staples in the early stages of a recession.
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As a recession continues, investors typically
rotate into the Utilities sector next because
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gas, electric, and water bills also have to
be paid during an economic downturn.
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When a recession worsens, investors might
move into the Healthcare sector because people
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are obviously willing to pay for healthcare
no matter what the economy is doing.
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Toward the tail end of the recession, investors
generally rotate into the Services sector.
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This sector includes waste management and
labor staffing.
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After rotating into Services, the economic
cycle usually starts over again, and investors
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might rotate back into Financials in anticipation
of growth and the end of the recession.
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So how can you identify the sectors that are
rotating in and out of favor under the ideal
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circumstances that we've covered?
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You can start by watching price trends among
the different sectors.
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If an economic recovery is well underway,
look for new upward trends to emerge in the
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Transportation, Industrials, and Basic Materials
sectors.
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Conversely, in the middle of a recession,
look for new upward trends in sectors like
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Utilities and Healthcare.
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Being aware of sector rotations can help active
investors adjust their portfolios.
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And although there may be indications of a
sector coming into or moving out of favor,
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remember that it's difficult to predict
with certainty and try to look for confirmation
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when possible.
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For example, if an active investor observes
that a sector might be coming into favor,
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she might hold existing investments in the
sector or look for new opportunities in that
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sector.
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On the flip side, if she observes a sector
seems to be going out of favor, she might
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raise stop losses or sell holdings within
that sector to cut losses or lock in profits.
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Applying sector rotation in these ways can
help investors manage a portfolio and even
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present new opportunities.
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But, sector rotation takes some time and experience
to learn.
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It's a good idea to go through at least
one economic cycle and observe how investors
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rotate from one sector to the next at each
stage of the cycle before making your own
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decisions based on sector rotation.
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