Have you seen it? It’s kind of hard to miss.
The stock market has been acting “unusual” in many ways these past two weeks. It may be signaling a harbinger of things to come.
There’s a significant difference between market volatility and market rotation. In the former, most recently experienced this past March, the entire market tends to ebb and flow in unison. Picture the undulating path of a roller coaster. As the car flies up and down at dizzying speed, the safest thing is to stay put. You’ll only hurt yourself if you try to exit the car in midflight.
Rotation is a bit trickier and it may be more relevant today. You ought to familiarize yourself with rotation.
In a nutshell, while volatility is a roller coaster, rotation is a pendulum. The weight of the market shifts from one sector or philosophy to another. Whereas with volatility the answer is almost always to ride out the storm, rotation calls you like a enticing siren, leading you into what often becomes a trap.
“Stock market rotations are more common than people may believe and should be considered depending on your investment style,” says Edward Canty of Investing Simple LLC in Ballston Spa, New York. “If you are more of a long term buy and hold investor then market rotations will be less of a factor for you. If you are more of an active or tactical investor, then you could consider market sentiment and rotation as a variable in your portfolio.”
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If you’ve got a strict discipline that you have mastered, then rotation can be your friend. Your stock valuation models will tell you what your sell price is and what your buy price is. Rotation, then, naturally flows from this. As prices get high, they reach their selling point and you harvest them to pick up candidates below their buy price. This is an organic rotation within your portfolio.
“Rotation can give investors an opportunity to overweight into underperforming sectors in the hope that they rotate into favor” says Randy Carver, President and CEO of Carver Financial Services in Mentor, Ohio.
Carver doesn’t recommend long-term retirement investors play this game. It requires a lot of time and effort to get right. And even then, it’s hard.
Instead, Carver recommends you “maintain an allocation which will ultimately rebalance into sectors that have underperformed in the hope that they move up. Over the years, the areas that underperform one year will often outperform in 1 or 2 years following.”
This is important advice for retirement investors, who generally count their time horizon in decades, not years. Furthermore, since retirement savers tend to delegate their investments to professionals, they may indirectly benefit from rotation since they’re relying on seasoned portfolio managers to navigate the market pendulum.
“Many newer investors have never seen stocks go down,” says Peter Davies, CEO of Jigsaw Trading in Bangkok. “Rotating between sectors is a skill and retirement savers should not do it just because it’s been in the press for a few days.”
Unlike the typical retirement saver, professional stock pickers are constantly looking at the price movements of individual companies. They have those disciplined valuation models that allow them to reap the rewards offered by rotation.
Ann Guntli, V.P., Portfolio Manager at RMB Capital in Chicago, says, “We are long-term investors and prefer to take a balanced approach to asset allocation focusing on high-quality stock and bond investments. For long-term investors, market rotations create opportunities to take advantage of dislocations in the markets and to selectively increase risk as opportunities present themselves.”
But this isn’t something you should try at home. Indeed, even those with experience can look at the same data and arrive at two diametrically opposed conclusions. For example, take a look at the back and forth between the value style and the growth style of investing. Some see this long overdue shift as occurring right now.
“The rotation into value stocks doesn’t have many implications for those retirement investors over the long-term,” says Ken Johnson, Investment Strategy Analyst at Wells Fargo Investment Institute in Charlotte, North Carolina. “Growth stocks (+7%) have outperformed value (+4%) over the past 20 years, however it’s not uncommon for value to outperform over extended periods of time. A lengthy rotation into value could narrow the gap between the two, however a diversified investor with a long time horizon should be well positioned either way.”
Robert R. Johnson, Heider College of Business Professor of Finance at Creighton University in Omaha, agrees with the conclusion but has a differing viewpoint on the historical data. He says, “Unless you are a retirement saver who is getting ready to access your funds, rotation from growth to value has virtually no impact. From 1927 through 2019, according to the data compiled by Nobel Prize laureate Eugene Fama and Dartmouth Professor Kenneth French, over rolling 15-year time periods, value stocks have outperformed growth stocks 93 percent of the time. Over rolling 10-year periods, value outperformed growth 82 percent of the time Over rolling 5-year periods, value outperformed growth 72 percent of the time. And, over annual periods, value outperformed growth 62 percent of the time.”
If the best answer to rotation, like that of volatility, is to simply stay put, how can rotation be a trap?
Many investors now understand the importance of riding the roller coaster. Anecdotal evidence from interviews with investment professionals suggests 401k investors ignored the big dip earlier this year.
This differs from their reaction in the 2008/2009 bear market (March of 2020 was also a bear market), when many fled their falling equity funds for “safe” stable income options. They jumped out of the roller coaster car and have the bruises to show for it.
They now know it rarely pays to time the market.
Here’s the problem: the same lesson needs to be learned when it comes to rotation.
“Market rotation is another way of trying to ‘guess’ market movements,” says Stuart Robertson, CEO of ShareBuilder 401k in Seattle. “In reality, no one can accurately predict markets including sector movements. Markets are unpredictable and it is typically hard to tell a rotation has occurred until after the fact.”
You cannot predict the future with any precision. You can correctly guess the general direction, but it’s awfully difficult to correctly guess the specific timing of that move.
“It is perilous to forecast exactly when the great rotation from growth stocks to value stocks will take place,” says Robert Johnson. “But, what I am comfortable with is the forecast that it will take place. Unless people believe that investors have fundamentally changed, the four most dangerous words in the English language with respect to investing is ‘This Time is Different.’ I am much more comfortable with Mark Twain’s observation that ‘History does not repeat itself, but it rhymes.’”
As a practical matter, despite the clear opportunities of rotation, retirement savers are better off sticking to what they can do something about: namely, saving. Leave the rest to the pros and don’t make any extreme bets.
“In theory, it should not matter much if the investors hold a broadly diversified portfolio with exposure to a wide range of market sectors,” says Steve Sosnick, Chief Strategist at Interactive Brokers IBKR in Greenwich, Connecticut. “It could certainly hurt if those investors are over-exposed to the high-flying stocks that fall out of favor. This can happen inadvertently if investors fail to re-evaluate their portfolios periodically.”
Spreading your eggs among many baskets doesn’t just apply to individual stocks or industry sectors, it all applies to market cap and growth/value stocks. “The key for investors is to be diversified so they are not invested solely in the investment style that goes out of favor,” says Chris Carter, Portfolio Manager at Navalign Wealth Partners in Los Angeles. “Having this diversified approach will help smooth returns over time.”
“A properly diversified portfolio or a market indexed portfolio will hold both growth and value, large companies and small, domestic and international and will not be overly sensitive to rotation toward or away from any particular discipline,” says Greg McBride, Chief Financial Analyst at Bankrate.com in Palm Beach Gardens, Florida. “As John Bogle was fond of saying, ‘Rather than picking needles out of a haystack, just buy the whole haystack.’”
More importantly, as rotation leaves old favorites lagging and old laggards leading, you might be tempted to switch strategies. In a word (actually a contraction): don’t.
“What it really means to long term investors is to stick with an investment method/style through a full market cycle to capture market level returns,” says Kelly Buckley, Managing Principal and owner of Spectrum Financial Alliance in Nicholasville, Kentucky. “Don’t chase styles or anticipate them. Deviations from mean market return (9-10% per year) are self-correcting if investors accept rotations and don’t try to defeat them.”
More concisely, you need to make your bed and then lie in it. Or, if you prefer a different metaphor, dance with the one that brought you.
“Long-term investors should position their portfolios for the long term,” says Chris Kampitsis, a financial planner at the Barnum Financial Group in Elmsford, New York. “In other words—they should do their best to avoid adjusting their portfolio for current trends or recent headlines. They would be better served by sticking to a defined investment policy and looking for assets and positions that adhere to that.”
Will your retirement win or lose with market rotation?
It all depends what you do or don’t do.