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Something odd happened last week. Something dramatic. Something that hasn’t happened in more than a decade and, arguably, not to this degree in nearly twenty years.
It’s called “rotation.” It’s not a new thing, and it has certainly occurred in much narrower market segments. But this is the first time in a long time when it has occurred in a general investment philosophy sense rather than a specific industry sense.
What is rotation?
“Market rotation is the counter movement from one equity class or sector into another,” says Ken Johnson, Investment Strategy Analyst at Wells Fargo Investment Institute in Charlotte, North Carolina. “Investors typically discuss it as the rotation between growth and value stocks or defensive and cyclical stocks.”
This is different than an industry or company specific story. In those instances, the news impacts only an isolated part of the day’s trading activity. For a rotation to occur, you must see traders selling one group of stocks and buying another group of stocks. This requires that former group to be overvalued and the latter group to be undervalued.
“Market rotation refers to a period of time when a stock market sector, market capitalization, region, or style that had previously been struggling starts outperforming and becomes the market leader,” says Ann Guntli, V.P., Portfolio Manager at RMB Capital in Chicago. “A market rotation can be long-term when a cycle of return changes for longer periods of time (for example, performance rotation between the U.S. and international markets), or short-term when the rotation only lasts for a few days or a week. Most recently, the stock market experienced two rotations: (1) from growth stocks to value stocks, and (2) from large-cap stocks to small-cap stocks.”
An external incident often triggers the onset of a rotation. Whether that movement has staying power depends on the nature of that affair. If it creates a watershed event, the shift goes beyond a momentary behavioral reaction to a full-scale change in the sales and profits of companies.
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You’ll see this during “a period of time when the underlying fundamentals in the economic, political, or social environment change,” says Edward Canty of Investing Simple LLC in Ballston Spa, New York. “Market rotations occur after a dynamic change in the base case scenario of the market. A market rotation can occur across asset classes, sectors, or regions.”
Essentially, rotation, no matter if you see it between sectors or within the entire market, “is a theory of stock market trading patterns that performance shifts from sector to sector,” says Randy Carver, President and CEO of Carver Financial Services in Mentor, Ohio. “For example, after the vaccine was announced on November 9th, tech stocks retreated while large cap blue chips advanced.”
If rotation is a common market phenomenon, why haven’t you seen or heard much about it until lately?
“We have seen very little rotation because many investors follow trends and are loathe to abandon those trends that are working well,” says Steve Sosnick, Chief Strategist at Interactive Brokers in Greenwich, Connecticut. “Large cap tech stocks have been the market leaders for some time. During periods of economic uncertainty investors tend to favor companies with consistent earnings and really favor those that have shown the ability to grow those earnings. They have also thrived during a decade plus of monetary expansion, partly because low interest rates can be used to justify high valuations. If one uses a discounted cash flow model for valuing shares, a near-zero interest rate can be used to justify high price/earnings ratios. Finally, we saw a flood of money come into the market this year from newly minted investors. Less experienced investors tend to gravitate towards household names with solid performance. That reinforced the existing trends.”
If you were watching closely, you would have seen a “micro” rotation over the course of 2020. Although Covid initially scared the entire market, it didn’t take long for potential winners to emerge. Investor money shifted towards those stocks.
“At the genesis of the coronavirus outbreak we saw a rotation from broader consumer stocks to so called ‘stay at home’ or ‘work from home’ stocks,” says Robert R. Johnson, Heider College of Business Professor of Finance at Creighton University in Omaha. “Firms like Zoom, Peloton and Netflix benefited to the detriment of Marriott, United Airlines and Carnival.”
The investing world changed suddenly with Pfizer’s vaccine announcement. “The stock market recently saw a rotation away from large-cap growth companies that have led performance for most of 2020 (such as Apple, Microsoft, and Facebook),” says Guntli, “and toward smaller-capitalization companies as well as more cyclically focused value sectors like energy and financials.”
“We have started to see a recent rotation that has emerged across sectors in the US stock market,” says Canty. “As investors begin to prepare for the reopening of the economy and easing of lock-downs, the sectors that have been most affected are beginning to rebound. As the high-flying tech stocks that have had a positive impact from the Covid shut downs begin to fade, investors may be taking profits and finding other sectors where there are more reasonable valuations. Financials, materials, and industrials are some of the Covid epicenter stocks that are beginning to attract capital.”
From a narrative standpoint, the evidence is quite compelling that the markets are on a cusp of a rotation the likes of which have not been seen in more than a decade.
“The thesis offered by many as to recent market activity was related to hope of economic improvement related to potential Covid vaccines,” says Chris Kampitsis, a financial planner at the Barnum Financial Group in Elmsford, New York. “The thought was that the ‘Stay-at-home’ stocks, which are mostly technology-driven growth equities, would slow down a bit in terms of their pace of growth while more traditional, value-oriented firms would benefit from an economic reopening. Whether any of this is will actually play out remains to be seen and long-term investors should be very cautious about making their decisions around short-term headlines.”
You do have a ways to go before you see enough data points (yet) to necessarily come to the conclusion that a new rotation is really underway. “You can’t say we saw a market rotation this past week,” says Stuart Robertson, CEO of ShareBuilder 401k in Seattle. “A few days of trading is not typically a good judge of any such movement. Further, it has not been declared we are in the next stage of an economic cycle.”
Despite the fact you don’t know for sure if we’re in the midst of a new rotation, it remains a healthy perspective to be prepared for the inevitable.
“Rotations happen,” says Dan Passarelli, President of Market Taker Mentoring in Frankfort, Illinois. “And when they do, investors need to consider which stocks and industries will fall out of favor and which are likely to take the lead. It requires action on the part of investors.”
So learn all you can about the current rotation before you try to do anything about it.