Introduction
The economy works in a cycle in which various sectors work like multiple interconnected gears. Changes in one sector have a cascading effect which affects multiple sectors of the economy. Similar to the economy, the stock market is composed of multiple sectors. According to the NSE official website, there are many sector indices which are part of Nifty (which is the most popular index in the Indian stock market).
These indices represent the key sectors of the Indian economy such as Nifty IT, Nifty FMCG, Nifty Bank etc. A sectoral index such as Nifty bank consists of the biggest banks in India such HDFC bank, SBI, ICICI bank and many more. The performance of the index is decided by the weighted average performance of the individual stocks which are present in the index. This is similar to how the performance of Nifty 50 is calculated which is dependent on the performance of all 50 stocks depending on their weightage in the index.
These sector indices work in an interconnected manner just like the actual sectors in the economy. E.g. A rising price of crude oil is great for oil & gas companies but can be a nightmare for paint companies. Similarly rising metal prices is good news for the metal companies but a big problem for the auto industry. Even small changes can cause cascading effects in the economy which gets reflected in the stock market.
What is sector rotation?
Sector rotation is the transfer of capital from one sector to another. This transfer of capital occurs as per the changing economic conditions which can be favourable for one sector while turning out to be unfavourable for another sector. Active investors look for these opportunities to shift their capital to the sectors which are best suited for the current economic condition.
In terms of the stock market, sector rotation could mean a transfer of capital from Banks to Pharma or a transfer of capital from IT to Realty. These sector rotations occur in the stock market frequently depending on the economic conditions.
Why is a rotation required? Can’t all sectors move together?
Some of you might be wondering, why is a rotation required at all. If the economic conditions are good for growth, can’t all sectors move higher together? The answer is NO! There is a finite amount of capital in the world. If you are completely invested in the stock market & suppose you find a good opportunity to enter IT stocks, you will have to sell other stocks to buy the IT stocks. Nobody (retail investors, FIIs, DIIs or mutual funds) has infinite money at their disposal. For a sector to go up, another sector has to come down!
Reasons for sector rotation
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Specific sectors become overvalued/undervalued
This happens in the stock market all the time. Some sectors outperform the stock market to the point of becoming extremely overvalued while other sectors underperform to the point of becoming extremely undervalued. In such a scenario, capital gets shifted from the overvalued sectors to the undervalued sectors. Some sectors become the hottest sectors in the stock market where everyone is going euphoric about buying the stocks at any price regardless of the valuations. Big investors book profits from such stocks and shift to another sector which is undervalued.
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Cyclical sectors
Some sectors are cyclical in nature such as Nifty metal. These sectors have cycles which can last from a few months to a few years. Investors need to be very active while investing in such sectors because these are not consistent compounders, rather these are sectors which often go downhill after a big peak. Cyclical sectors, by their very name, suggest a sector rotation. To learn more about why everything in the stock market works in a cycle, visit this article!
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Changes in technology
A change in technology plays a big role in terms of shaking up the landscape of the industries. The latest example of a change in technology is the rise of the EV (electric vehicles) which can be a big dent in companies still relying on conventional petrol & diesel engines in the long term. Another example is the shift from fossil fuel based energy to renewable energy which can lead to sector rotations in the long term. Such changes in technology lead to the money flowing from sunset industries (whose are past their prime) to sunrise industries (who are the hungry for growth).
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Government policies
Government policies can sometimes play a big role in determining which sectors can outperform or underperform in the stock market. An incentive from the government for an industry can lead to huge growth for the industry for multiple years. Whereas an increase in tax on another industry’s goods can stifle the growth of the industry. These policies (or changes in these policies) are tracked closely by big funds because they can play a pivotal role to make or break an industry! This is why sector rotations are often observed when a big announcement is to be made from the government such as the annual budget.
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USD-INR exchange rate
The exchange rate between US dollar and India rupee plays a big role for specific industries. Even though almost all companies have exposure to the USD-INR exchange rate, some industries such as Pharma & IT earn a big chunk of their capital in US dollars. The strengthening or the weakening of the rupee compared to the US dollar can play a direct impact on the revenue of these companies. Strengthening of the rupee is almost always a bad sign for such industries because they earn less in rupees for the same amount of US dollars!
Conclusion
Investors can take advantage of these sector rotations for the final goal of “outperforming the stock market”. However, this sector rotation must be used in caution because an incorrect shift can lead to a double blow when the sector exited outperforms & the sector entered underperforms. The final decision on their investment strategy depends on the reader!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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