Sector Rotation across the Business Cycle

Ben Jacobsen1 Jeffrey Stangl2 Nuttawat Visaltanachoti3

Massey University - Department of Finance and Economics

First draft: July 2006 This draft: December 2009 Abstract Conventional market wisdom posits that sector rotation over various stages of the business cycle generates market outperformance. We introduce a simple way to test the value of sector rotation. In our test, an investor anticipates business cycle stages perfectly and rotates sectors in accordance with conventional practice. Even with perfect foresight and ignoring transactions costs, sector rotation generates, at best, a 2.3 percent annual outperformance from 1948 to 2007. In a more realistic setting, outperformance quickly dissipates. We do find an alternative rotation strategy that historically beats the market by 7 percent. Whether by chance or due to fundamentals time will tell.

JEL Classifications: E32, G10, G12 Keywords: market timing, sector rotation, business cycle, investment strategies

Massey University, Department of Economics and Finance, Private Bag 102904, North Shore Mail Centre, Auckland, New Zealand 0745, E-mail: b.jacobsen@massey.ac.nz 2 Massey University, Department of Economics and Finance, Private Bag 102904, North Shore Mail Centre, Auckland, New Zealand 0745, E-mail: j.stangl@massey.ac.nz 3 Massey University, Department of Economics and Finance, Private Bag 102904, North Shore Mail Centre, Auckland, New Zealand 0745, E-mail: n.visaltanachoti@massey.ac.nz This paper benefits from presentations at the Australian Banking and Finance Conference (2007), the New Zealand Finance Colloquium (2007), the Financial Services Institute of Australia Conference (2007), the Auckland University of Technology, and the FMA Annual Meeting (2009). We thank Russell Gregory-Allen, Henk Berkman, Utpal Bhattacharya, Ben Marshall, and Phillip Stork for valuable comments and the Institute of Finance Professionals New Zealand for awarding this paper the Best New Zealand Paper in Investments 2007.

Electronic copy available at: http://ssrn.com/abstract=1572910

Sector Rotation across the Business Cycle

Abstract Conventional market wisdom posits that sector rotation over various stages of the business cycle generates market outperformance. We introduce a simple way to test the value of sector rotation. In our test, an investor anticipates business cycle stages perfectly and rotates sectors in accordance with conventional practice. Even with perfect foresight and ignoring transactions costs, sector rotation generates, at best, a 2.3 percent annual outperformance from 1948 to 2007. In a more realistic setting, outperformance quickly dissipates. We do find an alternative rotation strategy that historically beats the market by 7 percent. Whether by chance or due to fundamentals time will tell.

JEL Classifications: E32, G10, G12 Keywords: market timing, sector rotation, business cycle, investment strategies

2
Electronic copy available at: http://ssrn.com/abstract=1572910

1. Introduction According to the Fidelity website4, technology stocks outperform the market index after a trough in the business cycle. Just after a peak, investors are better off putting their money in Utilities. Other financial websites and advisors share Fidelitys view on when specific sectors should perform well over the business cycle. Standard & Poors and the website Marketoracle.co.uk recommend Technology after a recession. With the onset of an economic slowdown, Goldman Sachs5 and CNN Money6 advised investors to target Utilities. Conventional wisdom has a perspective on which sectors perform well across the business cycle and most professional investors seem to agree. Even though, as some suggest, if you are in the right sector at the right time, you can make a lot of money very fast,7 translating popular beliefs into an exact sector rotation strategy is not straightforward. The problem is to identify exact turning points and stages of the business cycle contemporaneously. This lack of clarity may explain why, to date, academic research has not rigorously tested whether investors can profit from sector rotation based on conventional wisdom.

Please insert Figure I around here.

While we cannot test whether actual sector rotation works, we can test the fundamental assumptions underlying sector rotation. Do sector returns differ significantly and predictably across the business cycle? Does rotating sectors in accordance with popular belief outperform a simple buy-and-hold strategy? We answer these questions using a simple but new approach. We give sector rotation the benefit of the doubt and assume an investor who perfectly predicts stages and turning points of the business cycle. As Bodie, Kane and Marcus (2009) comment:
4 5

http://personal.fidelity.com/products/funds/content/sector/cycle.shtml Reuters (2008) 6 CNN Money (2006) 7 Business Week Online (2002)

3
Electronic copy available at: http://ssrn.com/abstract=1572910

... sector rotation, like any other form of market timing, will be successful only if one anticipates the next stage of the business cycle better than other investors, (pg. 574). If the business cycle indeed drives sector returns, then a clairvoyant investor who perfectly times business cycle stages and rotates sectors using conventional wisdom should at least outperform the market. We then consider how relaxing this perfect foresight assumption and including transaction costs affects performance. Lastly, to allow for variations in conventional wisdom on sector rotation, we document whether in general any sector provides systematic outperformance during any business cycle stage.

In our perfect scenario, the evidence favors sector rotation, but only marginally so. Our base case covers the 19482007 period using phases of economic expansion and recession, as defined by the National Bureau of Economic Research (NBER). We divide NBER phases into smaller sub-periods that coincide with business cycle stages where popular belief expects optimal sector performance. With a few exceptions attributable to chance sectors that should perform well in various stages show no significant outperformance. When we combine sector returns across stages to implement a sector rotation strategy, we find that investors guided by conventional market wisdom and foresight of business cycle stages achieve risk corrected outperformance of 2.3 percent annually, excluding transactions costs. To put this figure in perspective, we note that for such clairvoyant investors it is easy to design better market timing strategies.8 When we relax assumptions and add transaction costs, the outperformance quickly dissipates.

For instance, a simple market timing strategy that invests continuously in the market except during early recession generates 2.5 percent outperformance in comparison with 2.3 percent for sector rotation.

We verify the robustness of our base case and consider a range of alternative tests, data sets, performance measures, samples, and approaches. We test whether results differ when investors anticipate changes in turning points earlier or later. However, this worsens outperformance, which drops from 2.3 percent to 1.9, then 1 percent when investors implement sector rotation one and two months in advance. Outperformance drops to 2.2 and 1.8 percent when investors delay sector rotation by one and two months, respectively. In addition to NBER business cycles, we construct business cycle stages from the Chicago Federal Reserve National Activity Index (CFNAI). The Chicago Federal Reserve Bank builds the CFNAI from well-known financial and economic variables that, according to the literature, signal changes in the business cycle. Whether we construct stages from the CFNAI or use different business cycle proxies suggested in the literature, like term-spread, defaultspread, dividend yield, unemployment, and industrial production, our main result holds. When we divide the sample period in half and look at the two different sub-periods, we find no performance improvement. When we divide stages in half, we find no significant differences between the first and the second half of each stage. Various performance metrics does not affect results, regardless of whether we use traditional measures such as Sharpe ratios and Jensens alphas or more recent performance measures like the Goetzmann, Ingersoll, Spiegel and Welch (2007) manipulation-proof performance measure. We verify whether our results depend on the measure of relative outperformance. For instance, Chordia and Shivakumar (2002) and Avramov and Chordia (2006) show that size, value, and momentum factors track business cycles. However, results are similar whether we measure outperformance using the single index model, the Fama and French three-factor model, or the Carhart four-factor model. As an alternative to industry returns, we consider more broadly partitioned sector return data using Standard & Poors sector indices, Fama and French sectors, and Fidelity Sector Select funds; these different data sets and partitions still leave our main result intact.

We can find no improvement on our base case scenario. Our results suggest that the popular belief that sector rotation might work is, at best, only marginally correct. Different sectors do not, significantly and systematically, outperform other sectors across business cycles, as conventional market wisdom maintains. To be clear, we do not preclude the possibility that there are practitioners who profit from sector rotation. Our results indicate that the outperformance of such investors has little to do with what conventional wisdom holds is the main driver of sector rotation outperformance: systematic variation in sector returns across the business cycle.

We focus on what one might call mainstream conventional wisdom on sector rotation, as codified, for instance, by Stovall (1996) and illustrated by the Standard & Poors sequence of cyclical sector performance shown in Figure I. However, as also illustrated in Figure I, other variations exist. Therefore, as a last robustness check, we test for consistent and significant outperformance of any sector across any business cycle stage, not just the mainstream conventional wisdom sectors. This test allows for all possible variations of conventional wisdom on sector rotation. None of the results suggests that any variation in conventional wisdom would outperform. We believe, with respect to this general test of sector performance, that there are two ways to interpret our evidence. If we consider the outperformance alphas (Jensen, Fama and French, or Carhart), one might argue they are well in line with the hypothesis of no significant sector outperformance, irrespective of business cycle stage. We find significance levels only marginally different from those expected to occur randomly in the absence of any outperformance. However, there appears to be evidence for an alternative sector rotation strategy, one that is not a variant of any conventional wisdom strategy with which we are familiar. We are uncomfortable rejecting this alternative strategy

outright as the result of data mining. In our sample, this strategy generates economically large outperformance of 7 percent annually. The strategy survives most of our robustness checks, although sometimes only marginally. Although, with hindsight, justification of any strategy is possible, one could also argue that there might be underlying fundamental reasons for the sectors that outperform in various stages. For instance, food and entertainment do well during recession, which might reflect the idea that consumers indulge in small pleasures during recessions. Nevertheless, contrary to the conventional wisdom case that dictates when certain sectors should perform relatively well, we believe it too soon to determine whether these outperformance results are due to chance or are the result of economic fundamentals.

This studys contribution to the literature lies in the fact that it is the first to question the underlying assumption that the business cycle offers opportunities for profitable sector rotationat least in the way conventional wisdom suggests. The perfect foresight approach gives sector rotation the benefit of the doubt and allows us to test its performance. Sector rotation seems popular among both professionals and individual investors, based on the number and types of websites dedicated to the topic. Sector rotation returns about 95,400 hits on Google compared with 833,000 and 878,000 for more generic terms like market timing and stock picking.9 Bodie, Kane and Marcus (2009) state that the notion of sector rotation is one way that many analysts think about the relationship between industry analysis and the business cycle, (pg. 573).10 Indeed, the CFA curriculum includes sector rotation as part of the core body of knowledge essential for investment professionals. However, even

10

July 2009. Other textbooks also confirm the important role of sector rotation. For instance Fabozzi (2007) states, Sector rotation strategies have long played a key role in equity portfolio management. (p.581). Recent papers that suggest that sector rotation plays an important role in mutual funds include, for instance, Elton, Gruber and Blake (2009) and Avramov and Wermers (2006).

though there are a number of sector rotation funds,11 it is difficult to obtain exact figures.12 One family of mutual funds alone, Fidelity Select, offers investors a choice of 42 sector funds.13 The number of sector exchange traded funds has also seen incredible growth from less than 10 in 1998 to over 180 in 2008 with a total net asset value of over 50 billion USD.14

While this is the first study to consider sector rotation practiced according to conventional wisdom, interest in sector rotation and industry allocation is growing. Several recent studies consider sector rotation and other time variations in sector and industry returns. Avramov and Wermers (2006) suggest a link between mutual fund performance related to industry allocation and business cycle proxies. Hou (2007) finds a significant lead/lag relation between the different responses of sectors to new economic information. Commodity or basic material industries respond more quickly to economic news than consumer goods industries. Hong, Torous and Valkanov (2007) and Eleswarapu and Tiwari (1996) observe that sectors with strong business cycle links, such as the metals, services, and petroleum sectors, lead the general market by as much as two months. Menzly and Ozbas (2004) show how sector performance relates to its position in the production and consumption supply chain. Conover, Jensen, Johnson and Mercer (2008) show how sector rotation using monetary conditions may generate outperformance. Jacobsen and Visaltanachoti (2009) show how sector market timing based on summer and winter patterns in US sectors outperforms a buy and hold portfolio. O'Neal (2000) finds that sector momentum is an indicator of future sector performance. A recent study by Beber, Brandt and Kavajecz (2009) observes sector order flows and finds evidence that order flows between sectors predicts future economic conditions.

11

Popular funds include the Rydex/SGI All-Cap Opportunity H (RYSRX), Rydex/SGI All-Cap Opportunity A (RYAMX), Claymore/Zacks Sector Rotation (XRO), and PowerShares Value Line Industry Rotation (PYH) 12 Investment Company Institute (2001) 13 http://personal.fidelity.com/products/funds/content/sector/products.shtml 14 Investment Company Institute (2009)

2. Business Cycles 2.1. NBER business cycle dates Our base case perfect world analysis covers ten business cycles from January 1948 to December 2007. Two considerations determine the starting point of our sample. First, we want to eliminate the possibility of business cycle distortions caused by the Great Depression or World War II.15 For instance, although the US economy was officially in a recession during 1945, industries still operated at full wartime production. Second, studies such as Stock and Watson (2002) suggest that business cycle duration changed after World War II. Fama (1975) in part attributes this change to adoption of the 1951 Federal Reserve Accord that allows the Federal Reserve Bank to moderate business cycles through interest rate adjustments.

The official U.S. government agency responsible for dating business cycles is the NBER. While NBER cycle reference dates are widely accepted by academics and practitioners, other measures of business cycle activity are also available.16 The NBER provides dates for cycle peaks and troughs that define phases of economic expansion and recession (Table I, Panel A). Panel A also reports business cycle duration from business cycle peak to business cycle peak. Since 1948, business cycles have lasted on average 71 months, with earlier cycles much shorter than more recent cycles, particularly during phases of expansion.

Please insert Table I around here.

15 16

See for example Chatterjee (1999) and Cover and Pecorino (2005) For a survey of business cycle dating methodologies see Chauvet and Hamilton (2005)

2.2. Business cycle stages While the NBER defines broad phases of economic expansion and recession, researchers and investment practitioners commonly divide these phases into smaller sub-periods. A study by DeStefano (2004) divides business cycles into two stages of expansion (early/late) and two stages of recession (early/late). Investment professionals and practitioner guides such as Stovall (1996) commonly divide expansions into three stages (early/middle/late) and recessions into two stages (early/late) to allow for the much longer duration of economic expansions. We follow this convention.17

Please insert Figure II around here.

We measure three stages of expansion (of equal length) from the first month following a cycle trough date to the subsequent cycle peak date and two equal length stages of recession from the first month following a cycle peak date to the subsequent cycle trough date. We define our five business cycle stages as early expansion (Stage I), middle expansion (Stage II), late expansion (Stage III), early recession (Stage IV), and late recession (Stage V). Table I, Panel B reports the duration of expansions, recessions, and stages over the 10 business cycles in the post-1948 period along with averages. Expansions last approximately five years on average and recessions 10 months.

17

For clarification, we adopt the common usage of the term sectors as broad segments of the economy with industry sub-units. Sector rotation itself is a top-down strategy based on the expectation of sector performance across business cycles with strategy implementation typically at the industry or firm level. For example, Table II shows that the Utility sector has two industries, Gas & Electric and Telecom.

10

3. Sector performance across business cycles 3.1. Data description For our base case scenario, we use market, industry, and Treasury bill return data from the Kenneth French website.18 Market returns represent the total value weighted returns for all NYSE, AMEX, and NASDAQ listed stocks. We use the 49 Fama and French industry portfolios and omit the Other portfolio for a total 48 industries. The one-month Treasury bill serves as a proxy for the risk-free interest rate. For clarity of interpretation, we report all results as continuously compounded annualized returns.

Please insert Table II around here.

3.2. Popular guidance on industry performance Table II shows the particular stage of the business cycle where conventional wisdom suggests sectors perform best. We follow Stovall (1996) in his popular practitioner guide to sector investing. Stovall (1996) divides the economy into ten basic sectors, and then maps the optimal performance of industries within each sector to one of five business cycle stages.19 For example, the Stovall guide suggests that technology and transportation sectors provide the best early expansion performance, basic materials and capital goods the best middle expansion performance, and so forth with outperformance shifting from one sector to the next across the remaining business cycle stages. We map each industry portfolio to its corresponding sector, then map each sector to the conventionally accepted business cycle stage of expected sector outperformance, as embodied by the Stovall (1996) classification.

18

See http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html for further detail on the data and the formation of industry portfolios. 19 Lofthouse (2001) traces a similar approach back to Markese (1986). There are other strategies as well. Salsman (1997) describes an alternative strategy that uses not only the dividend yield (as we do) but also shortterm interest rates combined with precious metals prices.

11

3.3. Nominal industry performance As an initial test, we simply observe nominal industry performance, with no risk adjustment, to determine whether there are significant differences over the course of a business cycle and, if so, whether this performance coincides with conventional wisdom. The computer software sector, for example, should outperform the market during the first stage of expansion and the basic materials sector should outperform during the second stage of expansion. We use equation 1 to estimate nominal industry performance by business cycle stage and report our results, along with some additional descriptive statistics, in Table III.

ri , t =

s =1

i,s

D s ,t + t

(1)

We define ri,t as nominal industry returns and Ds as a dummy variable that indicates one of five business cycle stages. As an example, D1 takes the value of one during months of early expansion and zero in all other months. Dummy variables D1, D2, and D3 correspond with the three stages of economic expansion (early/middle/late) and D4 and D5 with the two stages of economic recession (early/late). Thus, the i,s coefficients measure nominal industry returns for each of the five stages. For brevity, Table III reports industry results only for the stage where conventional wisdom suggests high performance. We report observations, annualized returns, standard deviations, betas, and autocorrelation coefficients (all measured during the indicated business cycle stage) along with average industry and market results beneath each stage. For comparison, Table III reports annualized industry returns over the full sample period in the last column. Lastly, Table III contains the p-values of a Wald test that these returns are significantly different across stages. However, in most cases we reject the null hypothesis of equal industry returns across the business cycle. This result is encouraging,

12

because if we could not reject the null hypothesis of equal returns, the practical usefulness of sector rotation as a strategy would be questionable from the start.

Please insert Table III around here.

We compare industry returns with market returns during each stage of expected performance as a simple measure of relative return. As an example, Table III reports transportation industry returns of 25 percent in comparison with 17 percent market returns during the months of early expansion. The transportation industry thus provides outperformance, as expected by conventional wisdom. The realization of expected outperformance does not occur in all cases. Out of the 48 industries, 33 have raw returns higher than market returns in the stage of expected outperformance. Thus, two out of three industries do offer higher nominal returns as expected.

Two stages show surprising results if we look at industry averages for those stages. The average 14 percent return for industries expected to perform well during early expansion yields a 3 percent underperformance compared with market return. Similarly, the average return for those industries that conventional wisdom expects to outperform during middle expansion is 1 percent less than the market return.

Based on this simple approach, popular belief holds true in the remaining three stages. In late expansion, early recession, and late recession, industries on average outperform the market as expected. Overall, it appears that nominal sector performance coincides only partially with popular belief. Observing the risk measures suggests that these results will become stronger if we use risk corrected outperformance. In early expansion and middle

13

expansion, we observe that on top of lower industry returns, industry risk is actually higher as measured by both beta and standard deviation. For the other three stages, we observe more mixed results with mostly lower betas but higher standard deviations.

It seems that, even with this crude approach, results are disappointing for sector rotation investing. Historically, many sectors would have done better during the early expansion and middle expansion stages, but these are not included in the popular sector rotation strategy. The more important question for an investor, and one that we address next, is whether risk adjusted industry outperformance differs significantly across business cycles.

Please insert Table IV around here.

3.4. Risk adjusted industry performance measures We next calculate the difference between industry and market Sharpe ratios, excess market returns, Jensens alphas, Fama and French (1992) three-factor alphas, and Carhart (1997) four-factor alphas for each stage. Table IV reports performance measures as annualized rates with White (1980) heteroskedasticity consistent t-statistics highlighted for statistical significance at the 10 percent level. We also test whether industry alpha performance measures differ significantly over business cycle stages with a Wald test statistic and report pvalues in Table IV under a null hypothesis of equal outperformance. For brevity, Table IV reports only results for the period of expected optimal industry performance.

14

Table IV starts with the difference between industry and market Sharpe ratios.20 If conventional wisdom holds, we would expect a positive and statistically significant Sharpe ratio difference. However, only one early recession industry (Gas & Electric) has a Sharpe ratio significantly higher than the market. All early expansion industries in the technology sector have statistically significant lower Sharpe ratios than the market. A large majority of late recession industries also have lower Sharpe ratio performance than the market, although here none of the differences are significant. The best average performance comes from late expansion industries, but again none is significantly different. Contrary to conventional wisdom, industries considered optimal for a particular period mostly underperform the market on a Sharpe ratio performance basis (28 out of 48 sectors). Sharpe ratios might over penalize for the idiosyncratic volatility inherent at the industry level. We next use alternative risk adjustments. Based on equation 2, we estimate excess market industry performance across business cycles. We run a regression of the difference between industry and market returns (ri-rmkt) on the cycle dummy variables (Ds) described above. The regression coefficient mkt is simply market outperformance for industry i during business cycle stage s.

ri ,t rmkt ,t = mkt ,i ,s Ds ,t + t
s =1

(2)

Additionally, we report Jensens alphas that we estimate for each stage of the business cycle with a modified market model using equation 3.

ri , t rf t =

s =1

J ,i , s

D s ,t +

s =1

1, i , s

( rm kt , t rf t ) D s , t + t

(3)

20

We estimate Ledoit and Wolf (2008) p-values for industry and market Sharpe ratio differences corrected for potentially non-iid returns and indicate statistically significant differences at the 10 percent level or higher in bold.

15

We define ri-rf as excess industry returns above the one-month Treasury bill, Ds as one of five business cycle timing variables, and rmkt-rf the market risk premium.

To ensure our results do not depend on specific risk factors, we include Fama and French (1992) three-factor and Carhart (1997) four-factor alphas. We estimate Fama and French alphas (F) with an equation similar to (3) where we now control for size and value risk factors in addition to market risk. We estimate Carhart alphas (C) with a modified four-factor model that adds an additional momentum factor to the Fama and French three-factor model.

Regardless of the measure, we find very little evidence of significant industry outperformance in stages when such industries should outperform as conventional wisdom maintains. These results strengthen our earlier findings for nominal returns. Based on Jensens alphas, we find six industries with significant outperformance. Based on the Fama and French three-factor model we find only five industries with significant outperformance in the stage where they should outperform, and only two using the Carhart four-factor model. At a 10 percent significance level, that is roughly the number of industries out of 48 expected to show random significant outperformance, even when none is present.21

As an additional step, we test for differences in market outperformance across the five business cycle stages (mkt) using a Wald test. We report p-values in Table IV under a null hypothesis of equal performance. If industry outperformance is unequal across business cycle stages, we should reject the null hypothesis. We cannot reject the null hypothesis of constant
21

If anything, it seems that Gas & Electric Utilities behave somewhat as popular wisdom suggests showing good relative performance during early recession. While performance is insignificant, it is positive and large, and the limited number of observations might explain the lack of significance.

16

excess market industry returns for 30 of the 48 industries. This result differs from the previous Wald test of constant nominal returns. Sensitivity to general market movements seems largely to explain differences in industry returns over business cycles. Wald tests of Fama and French and Carhart alphas also indicate no statistical difference in risk-adjusted industry performance across business cycles. Our results suggest that after controlling for risk using various measures, industry outperformance across business cycles does not occur or occurs only marginally so when conventional wisdom tells us it should.

Finally, in unreported results we count the percentage of months in the different stages where relative industry outperformance actually occurs and verify whether industries outperform more often in months when they should outperform based on popular belief. Again, we find no indication that this is the case.

4. Sector rotation performance Can a strategy of sector rotation still be profitable? We now focus on strategy implementation to observe the overall joint performance of sector rotation across the entire business cycle. In our base case scenario, we assume an investor who perfectly times NBER business cycles and at the start of each stage rotates industries according to conventional wisdom. We assume equal weights in industries held at each stage. We compare these results with a simple buy-and-hold strategy in Table V.

Please insert Table V around here.

17

The annualized outperformance of sector rotation based on perfect foresight amounts to 2.3 percent.22 This outperformance may appear large enough to be of interest to investors, but it represents a best-case scenario. Only an investor who followed popular market wisdom in the last 60 years, who ignored transactions costs, and who has perfectly timed all business cycles in accordance with the NBER although the NBER did it ex post would have realized this 2.3 percent outperformance. To put this number in perspective: an investor who had based on the same information just timed the early recession right and had held cash during that period and the market during the remainder of the business cycle would already have achieved a 2.5 percent outperformance. This same investor would also have had a better-diversified portfolio over time with less industry specific risk. We now consider what happens under assumptions that are more realistic, where we include transactions costs.

Transaction costs, both explicit and implicit, are difficult to estimate with any precision and depend on the stock, where it trades, and when it trades.23 We use a range of roundtrip transaction costs of between 0.5 and 1.5 percent given that estimates vary considerably and given changes in costs over the sample period.24 Estimated transaction costs include commissions, bid-ask spread, and market impact. Sector rotation has 50 roundtrip transactions and the market timing strategy we use for comparison has 20 roundtrip transactions over the full sample period. Once we include transactions costs, outperformance for the sector rotation strategy diminishes substantially to between 1.1 and 1.9 percent, statistically indistinguishable from zero. The alternative strategy based on market timing increases in relative outperformance owing to fewer transactions.
22

Since we estimate Jensens outperformance with a constant beta over the full sample period, outperformance does not equal the weighted average of industry outperformance by business cycle stage reported in Table IV. 23 See for example Goyenko, Holden and Trzcinka (2009) and Hasbrouck (2009). 24 Estimates of total trading costs vary greatly depending on the study. For instance, Lesmond, Schill and Zhou (2004) estimate roundtrip transaction costs of 1 2 percent for most large-cap trades while Keim and Madhavan (1998) estimate total round-trip transaction costs as low as 0.2 percent.

18

Thus far, our results indicate marginal outperformance, at best, of sector rotation implemented in accordance with popular wisdom, even if we give investors the benefit of the doubt and assume that investors correctly time the business cycle. Results for industries expected to perform well in the early expansion stage and the middle expansion stage are particularly disappointing. Still, it would be premature to conclude that sector rotation does not work. Investors may use different industry or sector classifications, different business cycle indicators, or different business cycle stages. Alternatively, investors may anticipate business cycles, which could generate outperformance. On the other hand, our results may be sample specific.

In our robustness tests, we consider all these possible explanations and several others. We use a range of alternative tests, data sets, performance measures, samples and approaches. We verify whether results improve if we assume investors anticipate changes in turning points earlier. In addition to NBER business cycles, we test various business cycle proxies and business cycle stages constructed from the CFNAI. We separate our sample in two subperiods and business cycle stages in two halves. We use sector returns from alternative data sources. We test obvious explanations for our results first, and then progressively relax more assumptions. 5. Robustness checks 5.1. Other data sets The Fama and French industries may not adequately represent the investment alternatives available to sector rotation investors. As such, we test three additional data sets that incorporate more broadly defined sector partitions: the Standard & Poors sector indices, the Fama and French sectors, and the Fidelity Sector Select funds.

19

The Standard & Poors indices provide a benchmark of sector performance frequently used by practitioners. There are a number of Standard & Poors indices. We use the 15 Standard & Poors indices available from Global Financial Data for the entire 19482007 period.

The Fama and French sectors comprise all NYSE, AMEX, and NASDAQ traded stocks mapped to one of 17 sector portfolios based on their SIC classification. It is less likely, using sector mapping, that one or two large firms will dominate portfolio returns.25 We obtain the Fama and French sector data from the Kenneth French website.

Although available only for a shorter period, the performance of Fidelity Sector Select funds provides a good proxy for sector rotation strategies implemented by individual investors. We source Fidelity Sector Select data for 42 funds from Morningstar services. The earliest start date is August 1981 for the Energy, Health Care, and Technology funds while the most recent start date is July 2001 for Pharmaceuticals. Due to the shorter Fidelity data series, and in order to use all available data, we extend the sample period from December 2007 to August 2008 for the Fidelity fund data. Even so, there are a very limited number of observations for the more recently added Fidelity Sector Select funds. Total return observations during recessions are further limited by the infrequency of recessions since 1981.

Please insert Table VI around here.

25

For instance, the Fama and French agriculture industry portfolio includes as few as four firms. Consequently, one can argue that results shown for the agriculture industry might merely measure firm specific developments unrelated to the business cycle.

20

Table VI provides a comparison of average statistics and performance measures for the different data sets mapped to where popular wisdom, codified by Stovall (1996), expects outperformance. Here again, there appears no consistency in sector performance regardless of data set. The Fama and French sectors slightly outperform in early expansion and early recession. Consistent with earlier results, late expansion and late recession industries perform best and early expansion industries largely underperform, although results are mostly insignificant. Only during late recession do the Fidelity sector funds outperform the market based on all performance measures, although not significantly so. However, this result might be due to a lack of observations. Alternative data sets do not seem to improve performance.

5.2 Different ways to measure business cycle We use the CFNAI and Conference Board Leading Indicator as alternatives to NBER cycle dates. As results for these two indicators differ only marginally, we focus on results for the CFNAI only. The CFNAI comprises 85 economic and financial variables from four broad categories: production and income; employment, unemployment, and hours; personal consumption and housing; and sales, orders, and inventories. CFNAI construction follows the methodology of Stock and Watson (1989) that uses first principal components of a large number of economic variables known to track economic activity. By construction, the CFNAI has a zero mean and unit standard deviation where a positive (negative) index value indicates above (below) trend economic activity. Publication of the CFNAI began in 2001 with series data available from 1967.26 In Figure III, we overlay the CFNAI index on NBER delineated phases of economic expansion and contraction (shaded area). We see that the CFNAI more or less tracks NBER cycle dates but shows some variation, which may better reflect the uncertainty investors face when they try to call business cycle stages in real time. Based on
26

More information is available at http://www.chicagofed.org/economic_research_and_data/cfnai.cfm

21

the CFNAI data we try three approaches. We form partitions at values of 0.57, 0.26, -.01, and
-.045 so as to divide the business cycle into five equal stages, then test for outperformance of

the conventional wisdom industries using dummy variables and regressions as above. As an alternative test, we partition CFNAI values according to the Chicago Federal reserve website, which defines values above 0.20 as late expansion and values below -0.70 as recession. We further subdivide these ranges into stages based on values we deem representative: early recession is the range from 0.0 to -0.70 and early and middle expansion split the 0.0 to 0.20 range.27 Thirdly, observing Figure III, it seems that on average positive CFNAI index levels and changes characterize an early expansion, and late expansion has positive index levels but mostly negative changes. In early recession, the CFNAI index has negative levels and negative changes and in late recession the index levels are still negative but changes are positive; our last test uses these characterizations. We run a regression for each sector where we test for sector outperformance based on levels and changes in the CNFAI index. We assign middle expansion sectors to early or late expansion depending on where they perform best. Again, this approach gives conventional wisdom the benefit of the doubt and illustrates that our results are independent of whether we consider four or five stages of the business cycle.

ri ,t rf t = 0 + 1CFNAI t + 2 CFNAI t + i (rmkt ,t rft ) + t

(6)

Please insert Figure III and Table VII around here.

Table VII Panel A reports a summary of average statistics and performance measures for industries grouped according to where they should outperform based on conventional wisdom

27

We omit results based on Chicago Federal Reserve cut-off points, as they are materially similar to those from equal CFNAI partitions; we provide them upon request.

22

now using CFNAI delineated stage partitions.28 Industry outperformance is even lower over CFNAI business cycle stages than previously observed with NBER delineated stages. Only late expansion industry mean returns are larger than their overall sample mean. Risk adjusted performance is no better. Average industry Sharpe ratios are lower than the market for all stages but late recession. All three alpha performance measures are mostly negative and none are statistically different from zero. There appears no improvement on our base case scenario if we use CFNAI rather than NBER measured business cycles. Panel B contains the results where we estimate the sensitivity of sectors to levels and changes of the CFNAI variable. We report bootstrapped p-values for the likelihood that the level and change coefficients jointly have the correct sign. We find only four industries at the 10 percent significance level, all in late recession (Recreation, Printing & Publishing, Apparel, and Textiles), that perform well when they are so expected. For all other sectors, there is no significant outperformance.29 This table suggests that only in late recession do some sectors perform significantly better than others do. Transportation, Electrical Equipment, and Business Services seem to recover faster than other sectors in late recession.

5.4. Timing the business cycle in advance or with a delay Investors might profit from consistently timing the business cycle incorrectly. Suppose that investors consistently assume that turning points occur earlier than the NBER dates or with a delay. If so, our base case scenario might underestimate actual outperformance of sector rotation. We advance the implementation of sector rotation by one month, two months, and three months prior to NBER business cycle turning points. Similarly, we consider delays up to three months. Table VIII contains our results excluding transactions costs.

28 29

For brevity, we report industry averages by business cycle stage and provide complete results upon request. For Steel Works (Middle Expansion) the joint probability that significant outperformance occurs in expansion is statistically significant.

23

Please insert Table VIII around here.

Overall performance declines monotonically and becomes insignificant as we rotate sectors further in advance of NBER business cycle stage turning points. The sector rotation Jensens alpha of 2.3 percent decreases to 1.9 and then 1.0 percent when we rotate sectors one, two, and three months early, respectively. Similarly, the alphas decrease if we assume investors respond with a delay. These results suggest the importance of precisely timing business cycle stages.

5.5. Different business cycle proxies The literature shows that several economic variables, like term-spread and default-spread, and dividend yield, proxy business cycles.30 If investors use these variables to predict the business cycle and rotate sectors accordingly, we can test more directly whether a model that predicts relative industry or sector outperformance, based on these proxies, aligns itself with the stages in which conventional wisdom suggest they should outperform.

We create a forecast model using the one-month Treasury bill, term-spread,31 defaultspread,32 and dividend yield as business cycle variables (BCV). Chordia and Shivakumar (2002) among others show that these variables lagged one period are a good predictor of momentum profits related to business cycles. Our forecast model uses monthly changes in the

See for instance, Campbell (1987), Chen (1991), Chen, Roll and Ross (1986), Fama and French (1989), Jensen, Mercer and Johnson (1996), Keim and Stambaugh (1986), Lewellen (2004), and Petkova (2006). 31 We calculate the term-spread as the difference between the 10-year Treasury constant maturity yield and the three-month Treasury yield. Fama and French (1989) find the term-spread closely tracks short-term business cycles and measures the difference between long-term growth and current short-term business conditions. The term structure is smallest (largest) at NBER defined business cycle peaks (troughs). 32 We calculate the default-spread as the difference between low-grade Baa and high-grade Aaa corporate bonds. The default-spread measures a default premium. Expected returns are greater for risky investments during times of economic uncertainty. As such, the default-spread should increase during periods of recession as investor required rates of return also increase.

30

24

business cycle variables as a proxy for unexpected shocks, as the literature shows that such changes provide the best forecast of asset prices.33 We forecast industry outperformance related to the business cycle with parameter estimates obtained from a regression of excess industry returns (ri-rf) on a constant, lagged changes in the business cycle variables (BCV), and excess market returns (rmkt-rf), using equation 7.

ri ,t rft = c0 + i BCVi ,t 1 + (rmkt ,t rft ) + t

i =1

(7)

Our model is the single index model with the inclusion of lagged changes in the business cycle variables to capture the relation between business cycle determinants and industry alpha performance. We essentially use the gamma parameter estimates (i) obtained from changes in the business cycle variables to forecast one period ahead Jensens alpha, where we decompose Jensens alpha to allow for the contribution of business cycle determinants to industry outperformance. Similar to Chordia and Shivakumar (2002), we use a 60-month rolling window to estimate the (i) forecast parameters. The rolling window moves forward each month to obtain i estimates from the most recent 60-month window. We then use the parameter estimates to forecast industry outperformance for the following

J ,t +1 ) measured with equation 8 as the sum of the gamma estimates times changes in month (
BCV ) . Each month current business cycle variable values from the proceeding period ( i t
i =1 4

we form a new sector rotation portfolio where we invest equal weights in all industries with forecast positive outperformance. The following month, we repeat the same process once again and continue this repetition over the entire sample period.
33

See for example studies by Chen, Roll and Ross (1986) and Keim and Stambaugh (1986), among others.

25

 BCV J ,t +1 = i t
i =1

(8)

To clarify with an example, in month 61 we first estimate the i parameters with month 1 to month 60 data. We next multiply the i parameter estimates by BCVi,61 measured as the (BCVi,61-BCVi,60) difference, to forecast a Jensens alpha attributable to business cycle determinants. Lastly, we select all industries where

BCV
i =1 i

> 0 for inclusion in a sector

rotation portfolio for a one-month holding period. The following month, we move the rolling window forward one month and repeat the entire process.

Please insert Table IX around here.

Table IX Panel A and Panel B overlays result from the forecast model on sector performance with NBER delineated business cycle stages. We wish to observe whether forecast industry outperformance coincides with the popular belief of sector rotation investors with respect to industry performance.34 Panel A reports the average number of industries the forecast model selects for inclusion in the sector rotation portfolio during each business cycle stage. On average, the forecast model selects approximately half of all industries for inclusion in the sector rotation portfolio during any given business cycle stage.

34

We also overlay the forecast model results on NBER business cycle substages, where we divide each stage into an early and a late stage and additional subperiods where we divide the sample. There is no change in our basic results for both substage and subperiod.

26

Panel B reports the percentage of time a particular industry is included in the sector rotation portfolio for the full period and for each business cycle stage. We would expect that if the business cycle variables were able to forecast industry outperformance related to the business cycle, and if industry performance aligns with popular belief, that the model would select an industry for inclusion in the portfolio during the period of expected optimal performance a high percentage of the time. However, the forecast model selects industries for inclusion evenly across the business cycle and independent of business cycle stage. (Values in bold indicate percentages that are significantly different from 50 percent at the 10 percent significance level.) Using this method, there also appears no evidence that sectors perform well when conventional wisdom suggests they should.

5.6. Description of other robustness tests35 5.6.1. Business cycle proxies: extended analysis We not only use relative sector outperformance forecasts based on business cycle proxies, but also seek to establish any correlation between them and sector performance. If conventional belief claims a sector should outperform during part of an expansion and we know that an economic variable is relatively high during expansion, we would expect to find a strong and positive link between outperformance of that sector when that economic variable is at a high level. We test this relation using the most common business cycle proxies (BCP): term-spread, default-spread, dividend yield, unemployment, and industrial production.

We first establish how these proxies behave across the business cycle. For instance, the literature shows that term-spread, default-spread, and dividend yield are smallest near economic peaks and largest near economic troughs (Fama and French, 1989). Stock and
35

All tables related to these results are available upon request from the authors.

27

Watson (1998) and Hamilton and Lin (1996) show how industrial production growth peaks and unemployment rates bottom out around business cycle peaks. Boyd, Hu and Jagannathan (2005) look at the impact on stocks of changes in unemployment across periods of economic expansion and recession. We confirm findings in the literature with changes in the business cycle proxies across successive stages that mostly have the expected sign and are statistically significant. For instance, changes in unemployment rates from one business cycle stage to the next are all significantly negative across stages of economic expansion and significantly positive across stages of economic contraction. Similarly, changes in default spread are negative during early and middle expansion and positive during early and late recession. Results tend to be less strong and insignificant for dividend yields.

Next, we investigate the connection between industry outperformance and these same proxies over the business cycle using equation 9.

ri ,t rf t = 0 + D p BCP , p BCPj ,t + mkt , p (rmkt ,t rf t ) + t

p =1

(9)

We regress excess industry i returns (ri-rf) during business cycle phase p (where phase is NBER expansion or recession) at time t on a constant, business cycle proxy j (BCPj), and a correction for excess market returns (rmkt-rf). Dummy variable Dp indicates the business cycle phase. The estimate BCP multiplied by the proxy value captures the contribution of the business cycle proxy to overall industry outperformance. To make our results independent of stages, we use full NBER expansion and recession periods rather than stages. For instance, term-spread becomes smaller across expansions and larger across recessions. Therefore, industries that should outperform during periods of expansion (recession) should have

28

negative (positive) term-spread coefficients. We observe significant coefficients with the correct sign about 9 percent of the time, more or less what we would expect to observe randomly at a 10 percent significance level. It appears that while the proxies do track business cycles as the literature suggests, we are unable to establish a link between these same business cycle proxies and industry outperformance. This general result holds regardless of how we partition the business cycle or whether we look at levels, one-month lags, or changes in the business cycle proxies.36

5.6.2. CFNAI forecasts of relative sector performance Analogous to our forecast model based on business cycle variables, we verify whether period ahead forecasts based on the CFNAI indicator fare better. There is no difference in our results when we use changes in the CFNAI indicator rather than changes in the various business cycle proxies; neither provides guidance for investors on sector rotation nor supports the view of conventional wisdom on sector performance linked to the business cycle.

5.6.3 Sequencing the industries As the Standard and Poors graph in Figure I shows, the outperformance of Technology follows outperformance of Utilities, and precedes outperformance of the Financials. The remaining figures suggest similar sequential patterns. We try a number of tests where we ignore the business cycle completely and verify whether outperformance of one sector predicts future performance of other sectors at some lag. We try lags up to 24 months for nominal returns and Jensens alphas. We find no evidence that the conventional wisdom
36

The correspondence between industry outperformance relative to the market and business cycle proxies measured across business cycle stages is materially similar, if not somewhat weaker, than across phases of expansion and recession. Similarly, the results hold regardless of whether we use level, one-month lags, or changes in the business cycle variables. For brevity, we limit our discussion to the link between industry performance across phases of economic expansion and recession using business cycle proxy levels and provide results of the additional tests upon request.

29

sequence of sector performance holds. We do find some one-month lead lag relations between sectors. However, beyond one-month lags, significant results seem to occur randomly.

5.6.4. Sub-stages We try a number of variations of the stages that could improve our base case scenario. Outperformance might only occur at the beginning or end of stages. To account for this possibility, we divide all stages into early and late halves then run our main tests again. We find no significant difference between first and second half returns across the stages. Investors also might anticipate different stages and react in shorter intervals around business cycle turning points rather than over the full length of a stage. We consider shorter periods where we test for significant outperformance for two, four and six months around turning points only. Again, we find no significant outperformance.

5.6.5. Sub-samples Significant events over a full 60-year sample period, like the 1970s bear market and the 1990s dotcom market could overly influence our results. We compare average performance measures for each stage for the 19481977 and 19782007 subperiods with the full sample period measures.37 Industry outperformance appears relatively constant across all periods and business cycle stages, regardless of the performance metric. Consistent with our previous analysis, early expansion and middle expansion industries provide inferior outperformance across both subperiods. Overall, our results do not seem sample specific.

37

The complete results for individual industries are available upon request.

30

5.6.6. Alternative Performance Measures We use two alternative measures to evaluate the performance of sector rotation, markettiming, and buy-and-hold strategies. The Goetzmann, Ingersoll, Spiegel and Welch (2007) performance measure eliminates any bias in Sharpe ratio or Jensens alpha measures of strategy performance attributable to potentially non-normal return distributions. The Barrett and Donald (2003) stochastic dominance test provides a test of strategy performance independent of asset pricing benchmarks. Even allowing for such considerations, different performance measures do not change our results.

6. General sector performance across the business cycle So far, we find little evidence in favor of sector rotation based on mainstream conventional wisdom. We acknowledge that variations on conventional wisdom, as Figure I illustrates, do exist. To allow for all possible variations of conventional wisdom on sector rotation, we take our results one-step further and test for consistent and significant outperformance of any sector across any business cycle stage. We also test how well a rotation strategy based on alternative sectors might perform.

As a first step, we consider the performance measures for all sectors in all stages. Under the null hypothesis of no significant outperformance, we would expect to find the different alphas almost normally distributed around zero. In Figure IV, we plot the expected distribution under the null of no outperformance and the actual distribution of Jensens alpha t-statistics (all other measures show similar patterns). At first sight, both plots seem similar. However, we find slightly more significant outperforming sectors than we would expect under the null hypothesis at a 10 percent confidence level (20 versus 12 out of 240 estimations). This number might be close enough to the null for some. Others might argue that it represents

31

almost double the number of outperforming sectors one would expect under the null. To err on the side of caution in accounting for any variants of sector rotation, we take a closer look at whether we can find any group of sectors that otherwise survives all our tests. We do find sectors with jointly significant Jensens, Fama and French, and Carhart alphas during particular stages of the business cycle. There are no such sectors in early expansion; Candy & Soda, and Pharmaceuticals in middle expansion; Mining, and Tobacco Products in late expansion; Shipping Containers, Food products, Utilities, and Entertainment in early recession; and Personal Services, Food Products and once more Tobacco Products in late recession.

Please insert Figure IV and Table X around here.

Historically, an alternative sector rotation strategy that holds the market in early expansion and then rotates sectors across the business cycle as above generates outperformance of 7.3 percent a year (6.1 percent assuming 1.5 percent round trip transactions costs as in Table V). These alternative sectors perform well in the months of the stages where they are supposed to perform well about 6070 percent of the time. If implemented 1, 2, or 3 months in advance, strategy returns reduce to 6.9, 6.1, and 4.9 percent and if implemented 1, 2, or 3 months late, to 7.2, 6.5, and 5.6 percent, respectively. All these sectors also outperformed in both the 19481977 and 19782007 subperiods, although not always significantly so. One could argue that this lack of significance indicates no outperformance. Alternatively, one might attribute this result to a lack of observations. Similar sectors and industries in other data sets also show outperformance, but not significantly so in all cases. Generally, the alternative strategy seems to survive all our robustness checks, although only marginally. Whether the outperformance of this alternative strategy is a result of data mining or a result of underlying fundamental

32

reasons we cannot determine. However, based on our results, it seems a more promising sector rotation strategy, and safer bet, than the traditional rotation strategy based on popular wisdom, if investors feel the business cycle contains information about sector performance.

7. Conclusion Despite exhaustive testing, we find little support for the conventional wisdom that sector rotation across business cycles outperforms the general market. Even if we give sector rotation the benefit of the doubt, and assume that investors perfectly time business cycles, returns are only marginally higher than the market. Our study goes one step further and relaxes any assumption of conventional wisdom to explore whether any sector consistently and significantly performs better in any business cycle stage. We find only limited evidence supporting the systematic performance of sectors across the business cycle. An alternative sector rotation strategy, which is not a variant of conventional wisdom sector performance, generates economically large outperformance of 7 percent annually. Whether this is due to chance or fundamentals, only the passage of time will tell. To avoid misunderstanding, our results do not preclude the possibility that an investor may profit from sector rotation. Different investments in sector funds, beyond the scope of this study, may indeed outperform the market. We simply show that sector performance fails to track business cycles, as conventional wisdom maintains it does or in general. Our results question popular belief in systematic sector outperformance across the business cycle.

33

REFERENCES Avramov, D., and Chordia, T., 2006, Asset pricing models and financial market anomalies, Review of Economic Studies 19, 1001-1040. Avramov, D., and Wermers, R., 2006, Investing in mutual funds when returns are predictable, Journal of Financial Economics 81, 339-377. Barrett, G., and Donald, S., 2003, Consistent tests for stochastic dominance, Econometrica 71, 71-104. Beber, A., Brandt, M., and Kavajecz, K., 2009, What does equity sector orderflow tell us about the economy?, Working Paper Series (SSRN) (SSRN). Bodie, Z., Kane, A., and Marcus, A., 2009. Investments (McGraw Hill Irwin). Boyd, J., Hu, J., and Jagannathan, R., 2005, The stock market's reaction to unemployment news: Why bad news is usually good for stocks, Journal of Finance 60, 649-672. Business Week Online, 2002, Get in, get out, and move on, (McGraw-Hill Companies, Inc.). Campbell, J., 1987, Stock returns and the term structure, Journal of Financial Economics 18, 373-399. Carhart, M., 1997, On persistence in mutual fund performance, Journal of Finance 52, 57-82. Chatterjee, S., 1999, Real business cycles: A legacy of countercyclical policies?, Business Review 17-27. Chauvet, M., and Hamilton, J., 2005, Dating business cycle turning points, NBER Working Paper. Chen, N., 1991, Financial investment opportunities and the macroeconomy, Journal of Finance 46, 529-554. Chen, N., Roll, R., and Ross, S., 1986, Economic forces and the sock market, The Journal of Business 59, 383-403. Chordia, T., and Shivakumar, L., 2002, Momentum, business cycle, and time-varying expected returns, Journal of Finance 57, 985-1019. CNN Money, 2006, Stocks that can ride a pause, (Cable News Network. A Time Warner Company). Conover, M., Jensen, G., Johnson, R., and Mercer, J., 2008, Sector rotation and monetary conditions, Journal of Investing 34-46. Cover, J., and Pecorino, P., 2005, The length of US business expansions: When did the break in the data occur?, Journal of Macroeconomics 27, 452-471. DeStefano, M., 2004, Stock returns and the business cycle, Financial Review 39, 527-547. Eleswarapu, V., and Tiwari, A., 1996, Business cycles and stock market returns: Evidence using industry-based portfolios, Journal of Financial Research 19, 121-134. Elton, E., Gruber, M., and Blake, C., 2009, An examination of mutual fund timing ability using monthly holding data, Working Paper Series (SSRN). Fabozzi, F., 2007. Fixed income analysis (Wiley). Fama, E., 1975, Short-term interest rates as predictors of inflation, American Economic Review 65, 269-282. Fama, E., and French, K., 1989, Business conditions and expected returns on stocks and bonds, Journal of Financial Economics 25, 23-49. Fama, E., and French, K., 1992, The cross-section of expected stock returns, Journal of finance 47, 427-465. Goetzmann, W., Ingersoll, J., Spiegel, M., and Welch, I., 2007, Portfolio performance manipulation and manipulation-proof performance measures, Review of Financial Studies 20, 1503-1546.

34

Goyenko, R., Holden, C., and Trzcinka, C., 2009, Do liquidity measures measure liquidity?, Journal of Financial Economics 92, 153-181. Hamilton, J., and Lin, G., 1996, Stock market volatility and the business cycle, Journal of Applied Econometrics 11, 573-593. Hasbrouck, J., 2009, Trading Costs and Returns for U.S. Equities: Estimating Effective Costs from Daily Data, The Journal of Finance 64, 1445-1477. Hong, H., Torous, W., and Valkanov, R., 2007, Do industries lead stock markets?, Journal of Financial Economics 83, 367-396. Hou, K., 2007, Industry Information diffusion and the lead-lag effect in stock returns, Review of Financial Studies 20, 1113-1138. Investment Company Institute, 2001. Investment Company fact book (Investment Company Institute). Investment Company Institute, 2009. Investment Company fact book (Investment Company Institute). Jacobsen, B., and Visaltanachoti, N., 2009, The Halloween effect in US sectors, Financial Review 44, 437-459. Jensen, G., Mercer, J., and Johnson, R., 1996, Business conditions, monetary policy, and expected security returns, Journal of Financial Economics 40, 213-237. Keim, D., and Madhavan, A., 1998, The cost of institutional equity trades, Financial Analysts Journal 54, 50-69. Keim, D., and Stambaugh, R., 1986, Predicting returns in the stock and bond markets, Journal of Financial Economics 17, 357-390. Ledoit, O., and Wolf, M., 2008, Robust performance hypothesis testing with the Sharpe ratio, Journal of Empirical Finance 15, 850-859. Lesmond, D., Schill, M., and Zhou, C., 2004, The illusory nature of momentum profits, Journal of Financial Economics 71, 349-380. Lewellen, J., 2004, Predicting returns with financial ratios, Journal of Financial Economics 74, 209-235. Lofthouse, S., 2001. Investment management (Wiley). Markese, J., 1986, The stock market and business cycles, AAII Journal 8, 30-32. Menzly, L., and Ozbas, O., 2004, Cross-industry momentum, Working Paper Series (SSRN). O'Neal, E., 2000, Industry momentum and sector mutual funds, Financial Analysts Journal 56, 37-49. Petkova, R., 2006, Do the Fama-French factors proxy for innovations in predictive variables, The Journal of Finance 61, 581-612. Reuters, 2008, Goldman Sachs sees recession in 2008, (Thomson Reuters ). Salsman, R., 1997, Using market prices to guide sector rotation, (CFA Institute). Stock, J., and Watson, M., 1989, New indexes of coincident and leading economic indicators, NBER macroeconomics annual 351-394. Stock, J., and Watson, M., 1998, Business cycle fluctuations in US macroeconomic time series, NBER working paper. Stock, J., and Watson, M., 2002, Has the business cycle changed and why?, NBER macroeconomics annual 159-218. Stovall, S., 1996. Standard & Poor's guide to sector investing (McGraw-Hill). White, H., 1980, A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity, Econometrica 48, 817-838.

35

Table I. NBER reference business cycle dates and stage partitions

Notes: Panel A shows NBER published business cycle peak and trough reference dates from January 1948 to December 2007. We count periods of recession as the first month following a cycle peak to the subsequent trough, and periods of expansion as the first month following a cycle trough to subsequent peak. The last column shows the total months in a business cycle from peak to peak. The last recorded NBER business cycle date is December 2007. Panel B shows the total duration in months for recessions and expansions based on the NBER turning points shown in Panel A. We partition NBER defined periods of expansion into three equal stages (early, middle, and late) and NBER defined periods of recessions into two equal stages (early and late). The bottom of Panel B shows the average duration of each stage.

Panel A: Peak 11/48 07/53 08/57 04/60 12/69 11/73 01/80 07/81 07/90 03/01

NBER business-cycle dates (Jan 1948 - Dec 2007) Trough 10/49 05/54 04/58 02/61 11/70 03/75 07/80 11/82 03/91 11/01 Peak 07/53 08/57 04/60 12/69 11/73 01/80 07/81 07/90 03/01 12/07 Cycle Length 56 49 32 116 47 74 18 108 128 81

Panel B:

Number of months in NBER delineated business cycle stages Period of Expansion Period of Recession Early Stage Middle Stage Late Stage Total Early Stage Late Stage Total 15 15 15 45 6 5 11 13 13 13 39 5 5 10 8 8 8 24 4 4 8 35 35 36 106 5 5 10 12 12 12 36 6 5 11 19 19 20 58 8 8 16 4 4 4 12 3 3 6 30 31 31 92 8 8 16 40 40 40 120 4 4 8 25 25 23 73 4 4 8 20 20 20 60 5 5 10 average:

36

Table II. List of expected best performing industries across business cycle stages
Notes: Table reports stages of business cycle where, based on the Stovall (1996) classification and popular investment websites such as those shown in Figure I, sectors/industries provide the best performance. We partition periods of expansion into three equal stages (early, middle, and late) and periods of recession into two equal stages (early and late). We then map each of the 48 Fama and French industries to its appropriate sector and business cycle stage.
Period of Expansion Period of Early Expansion - Stage I Middle Expansion - Stage II Late Expansion - Stage III Early Recession - Stage IV Technology: Basic Materials: Consumer Staples: Utilities: Computer Software Precious Metals Agriculture Gas & Electrical Utilities Measuring & Control Equip. Chemicals Beer & Liquor Telecom Computers Steel Works Etc Candy & Soda Electronic Equipment Non-Metallic & Metal Minin Food Products Healthcare Transportation: Capital Goods: General Transportation Fabricated Products Medical Equipment Shipping Containers Defense Pharmaceutical Products Machinery Tobacco Products Ships & Railroad Equip. Energy: Aircraft Coal Electrical Equipment Petroleum & Natural Gas Services: Business Services Personal Services Recession Late Recession - Stage V Consumer Cyclical: Apparel Automobiles & Trucks Business Supplies Construction Construction Materials Consumer Goods Entertainment Printing & Publishing Recreation Restaraunts, Hotels, Motels Retail Rubber & Plastic Products Textiles Wholesale Financial: Banking Insurance Real Estate Trading

37

Table III. Descriptive industry statistics by NBER delineated business cycle stages
Notes: Table reports nominal industry returns and standard deviations for the business cycle stage considered optimal by conventional wisdom as annualized rates. We estimate nominal industry returns for each business cycle stage with equation 1 where we regress industry returns on business cycle dummy variables (Ds) that take a value of 1 or zero depending on the business cycle stage. The beta estimate is from a standard single index model and rho (1) is the first order serial correlation coefficient across stages with statistical significance at 10 percent highlighted. We also report Wald test results for differences in industry returns across the five business cycle stages and report p-values under a null hypothesis of equal industry returns across the business cycle. For comparative purposes, we provide annualized industry returns for the full sample period in the far right column and equally weighted industry averages and market results beneath each business cycle stage. Column 2 also reports the number of industry return observations (obs.) included in a business cycle stage.

ri ,t = i ,s Ds ,t + t
s =1

(1)

Sample period: 1948-2007 Industry Early Expansion - Stage I: Computers Computer Software Electronic Equipment Measuring & Control Shipping Containers Transportation Industry Averages Market Middle Expansion - Stage II: Chemicals Steel Works Precious Metals Mining Fabricated Products Machinery Electrical Equipment Aircraft Shipbuilding & Railroad Defense Personal Services Business Services Industry Averages Market obs. 201 130 201 201 201 201 stage mean 0.13 0.00 0.17 0.10 0.18 0.25 0.14 0.17 std. dev. 0.22 0.34 0.25 0.22 0.17 0.17 0.23 0.13 beta 1.38 1.71 1.50 1.36 0.96 1.02 1.32 1.00 rho(1) -0.02 0.05 0.04 0.09 -0.01 0.05 0.03 0.03 Wald p-value 0.00 0.15 0.00 0.00 0.00 0.00 0.03 0.00

full sample mean 0.13 0.02 0.11 0.12 0.12 0.10 0.10 0.12

202 202 166 202 166 202 202 202 202 166 202 202

0.12 0.13 0.08 0.12 0.12 0.17 0.19 0.19 0.08 0.15 0.12 0.13 0.13 0.14

0.17 0.22 0.32 0.23 0.20 0.18 0.19 0.21 0.19 0.21 0.22 0.16 0.21 0.13

1.12 1.23 0.76 1.19 1.00 1.22 1.26 1.15 1.15 1.07 1.17 1.04 1.11 1.00

0.02 -0.03 -0.05 -0.05 -0.03 0.03 -0.03 0.10 0.00 -0.01 0.10 0.11 0.01 0.03

0.00 0.00 0.58 0.00 0.01 0.00 0.00 0.00 0.01 0.02 0.00 0.00 0.05 0.00

0.11 0.10 0.08 0.12 0.05 0.11 0.14 0.14 0.10 0.12 0.09 0.10 0.10 0.12

38

Table III. Continued

Sample period: 1948-2007 Industry Late Expansion - Stage III: Agriculture Food Products Candy & Soda Beer & Liquor Tobacco Products Healthcare Medical Equipment Pharmaceutical Coal Petroleum & Natural Industry Averages Market Early Recession - Stage IV: Utilities Communication Industry Averages Market Late Recession - Stage V: Recreation Entertainment Printing & Publishing Consumer Goods Apparel Rubber & Plastic Textiles Construction Material Construction Automobiles & Truck Business Supplies Wholesale Retail Restaurants & Hotels Banking Insurance Real Estate Trading Industry Averages Market obs. 213 213 166 213 213 136 213 213 213 213 stage mean 0.11 0.07 0.05 0.10 0.15 0.09 0.12 0.10 0.21 0.11 0.11 0.07 std. dev. 0.22 0.15 0.24 0.19 0.20 0.33 0.17 0.16 0.33 0.18 0.22 0.15 beta 0.81 0.61 0.74 0.81 0.40 1.16 0.86 0.70 1.02 0.74 0.79 1.00 rho(1) -0.06 0.03 0.01 0.00 0.11 0.09 -0.02 -0.05 0.08 -0.04 0.01 -0.02 Wald p-value 0.00 0.00 0.01 0.00 0.04 0.02 0.01 0.01 0.00 0.00 0.01 0.00 full sample mean 0.10 0.13 0.12 0.13 0.15 0.09 0.14 0.13 0.14 0.14 0.13 0.12

53 53

0.00 -0.04 -0.02 -0.16

0.16 0.14 0.15 0.16

0.76 0.63 0.70 1.00

0.11 0.06 0.09 -0.05

0.05 0.07 0.06 0.00

0.11 0.10 0.11 0.12

51 51 51 51 51 51 51 51 51 51 51 51 51 51 51 51 51 51

0.64 0.50 0.62 0.49 0.63 0.42 0.47 0.51 0.63 0.38 0.44 0.43 0.55 0.52 0.48 0.44 0.56 0.53 0.51 0.40

0.31 0.31 0.23 0.21 0.27 0.22 0.25 0.23 0.33 0.25 0.24 0.23 0.24 0.28 0.23 0.20 0.31 0.23 0.25 0.18

1.22 1.28 1.03 1.01 1.09 0.90 1.09 1.17 1.51 1.06 1.19 1.06 1.11 1.27 1.14 0.86 1.21 1.16 1.13 1.00

-0.13 0.19 0.29 0.12 0.17 0.07 0.05 0.03 -0.01 0.20 -0.07 0.13 0.27 0.04 0.11 0.14 0.06 0.12 0.10 0.11

0.00 0.10 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.02 0.01 0.00 0.00 0.01 0.00

0.09 0.14 0.12 0.12 0.10 0.12 0.10 0.11 0.12 0.11 0.11 0.11 0.12 0.12 0.12 0.12 0.07 0.14 0.11 0.12

39

Table IV. Industry performance measures by NBER delineated business cycle stages
Notes: Table reports differences between industry and market Sharpe ratios, excess market returns (mkt), Jensens alphas (J), Fama and French (1992) three-factor alphas (F), and Carhart (1997) fourfactor alphas (C) for the business cycle stage considered optimal by conventional wisdom. We report annualized alpha returns with White (1980) heteroskedasticity consistent t-statistics highlighted for statistical significance at 10 percent. To calculate Sharpe ratios, we divide returns in excess of the onemonth Treasury bill by the standard deviation of returns. We estimate Ledoit and Wolf (2008) p-values for industry and market Sharpe ratio differences corrected for potentially non-iid returns and indicate statistically significant differences at the 10 percent level or higher in bold. We estimate excess market returns, Jensens alphas, Fama and French alphas, and Carhart alphas by business cycle stage with equations 25 respectively using business cycle stage dummy variables (Ds) previously described. We also report Wald test results for differences in performance measures across the five business cycle stages and report p-values under a null hypothesis of constant industry performance. Table also reports equally weighted industry averages beneath each business cycle stage.

ri ,t rmkt ,t = mkt ,i ,s Ds ,t + t
s =1

(2) (3) (4)

ri ,t rft = J ,i , s Ds ,t + 1,i , s (rmkt ,t rft ) Ds ,t + t

s =1 5 s =1 5

ri ,t rft = F ,i , s Ds ,t + 1,i , s (rmkt ,t rft ) + 2,i , s SMBt + 3,i , s HMLt Ds ,t + t

s =1 s =1

ri ,t rft = C ,i , s Ds ,t + 1,i , s (rmkt ,t rft ) + 2,i , s SMBt + 3,i , s HMLt + 4,i , s MOM t Ds ,t + t (5)
s =1 s =1

Industries Early Expansion - Stage I: Computers Computer Software Electronic Equip. Measuring & Control Shipping Containers Transportation Industry Average:

Sharpe Ratio Difference -0.16 -0.21 -0.13 -0.19 -0.05 0.06 -0.11

Excess Market Wald p-value mkt -0.03 -0.12 0.00 -0.06 0.01 0.07 -0.02 0.48 0.55 0.29 0.06 0.10 0.00

Jensens alpha Fama-French alpha Wald Wald p-value p-value J F -0.08 -0.17 -0.06 -0.10 0.01 0.07 -0.05 0.32 0.88 0.94 0.05 0.12 0.00 -0.05 -0.18 -0.04 -0.07 -0.01 0.03 -0.05 0.92 0.85 0.94 0.22 0.15 0.08

Carhart alpha Wald p-value C -0.01 -0.19 -0.01 -0.06 -0.01 0.02 -0.04 0.90 0.83 0.90 0.22 0.15 0.10

40

Table IV. Continued

Sharpe Ratio Industries Difference Middle Expansion - Stage II: Chemicals -0.07 Steel Works -0.08 Precious Metals -0.14 Mining -0.10 Fabricated Products -0.07 Machinery -0.01 Electrical Equip. 0.01 Aircraft 0.00 Shipbuilding/Railroad -0.14 Defense -0.04 Personal Services -0.10 Business Services -0.04 -0.07 Industry Average: Late Expansion - Stage III: Agriculture 0.05 Food Products 0.00 Candy & Soda -0.06 Beer & Liquor 0.04 Tobacco Products 0.11 Healthcare 0.00 Medical Equipment 0.08 Pharmaceutical 0.05 Coal 0.10 Petroleum & Natural 0.07 0.04 Industry Average: Early Recession - Stage IV: Gas & Electric 0.33 Communication 0.23 0.28 Industry Average: Late Recession - Stage V: Recreation -0.04 Entertainment -0.13 Printing & Publishing 0.10 Consumer Goods 0.03 Apparel 0.02 Rubber & Plastic -0.07 Textiles -0.07 Construction Material 0.00 Construction -0.07 Automobiles & Truck -0.14 Business Supplies -0.08 Wholesale -0.08 Retail 0.02 Restaraunts & Hotels -0.07 Banking -0.04 Insurance -0.01 Real Estate -0.09 Trading 0.02 -0.04 Industry Average: Excess Market Wald p-value mkt -0.02 -0.01 -0.05 -0.01 -0.01 0.03 0.05 0.05 -0.05 0.01 -0.02 0.00 0.00 0.04 0.00 -0.03 0.03 0.08 0.01 0.05 0.03 0.14 0.05 0.04 0.20 0.15 0.17 0.18 0.07 0.16 0.07 0.17 0.01 0.05 0.08 0.17 -0.01 0.03 0.02 0.11 0.09 0.06 0.03 0.11 0.10 0.08 0.05 0.53 0.97 0.05 0.16 0.02 0.36 0.66 0.62 0.67 0.17 0.09 Jensens alpha Fama-French alpha Wald Wald p-value p-value J F -0.03 -0.03 -0.03 -0.03 -0.01 0.01 0.02 0.03 -0.07 0.01 -0.03 -0.01 -0.01 0.04 0.01 -0.03 0.03 0.09 0.01 0.05 0.04 0.14 0.05 0.04 0.13 0.05 0.09 0.10 -0.01 0.15 0.06 0.14 0.04 0.03 0.03 0.01 -0.03 -0.03 0.00 0.08 0.01 0.01 0.07 0.05 0.05 0.04 0.04 0.60 0.97 0.05 0.24 0.19 0.33 0.84 0.62 0.48 0.29 0.13 -0.03 -0.06 -0.07 -0.06 -0.04 0.00 0.02 0.01 -0.08 -0.02 -0.04 -0.01 -0.03 0.04 0.00 -0.04 0.03 0.08 0.01 0.05 0.04 0.13 0.04 0.04 0.12 0.04 0.08 0.06 -0.05 0.12 0.07 0.07 0.01 -0.02 0.00 -0.01 -0.07 -0.04 -0.01 0.04 -0.02 0.00 0.09 -0.03 0.03 0.01 0.16 0.32 0.97 0.01 0.16 0.26 0.39 0.96 0.58 0.52 0.48 0.16 Carhart alpha Wald p-value C -0.02 -0.05 -0.07 -0.06 -0.03 0.00 0.01 0.00 -0.08 -0.03 -0.03 -0.01 -0.03 0.04 0.01 -0.03 0.04 0.10 0.02 0.03 0.01 0.06 0.03 0.03 0.12 0.04 0.08 0.00 -0.04 0.08 0.00 0.08 -0.03 0.01 -0.03 0.03 -0.05 -0.04 -0.07 0.01 -0.04 -0.05 0.04 -0.12 0.05 -0.01 0.13 0.25 0.96 0.01 0.16 0.22 0.41 0.96 0.59 0.48 0.50 0.17

0.24 0.00 0.32 0.37 0.01 0.23 0.04 0.00 0.06 0.50

0.20 0.01 0.20 0.65 0.09 0.30 0.05 0.01 0.09 0.42

0.15 0.01 0.18 0.37 0.05 0.24 0.10 0.04 0.07 0.36

0.14 0.01 0.18 0.37 0.05 0.24 0.09 0.04 0.06 0.35

0.01 0.02

0.74 0.65

0.49 0.74

0.50 0.64

0.47 0.76 0.06 0.37 0.27 0.45 0.34 0.09 0.00 0.07 0.22 0.56 0.10 0.37 0.43 0.92 0.08 0.02

0.66 0.18 0.07 0.28 0.34 0.56 0.34 0.33 0.03 0.08 0.26 0.75 0.10 0.57 0.48 0.92 0.14 0.60

0.56 0.06 0.07 0.24 0.27 0.47 0.81 0.29 0.01 0.39 0.65 0.72 0.09 0.60 0.34 0.82 0.10 0.77

0.59 0.05 0.07 0.22 0.39 0.47 0.89 0.31 0.01 0.34 0.68 0.72 0.10 0.66 0.38 0.84 0.11 0.82

41

Table V. Comparison of market, sector rotation, and market timing performance

Notes: Table compares Jensens alpha and Sharpe Ratio performance measures for the market, sector rotation, and market timing after allowing for a range of transaction costs. The market strategy invests in the market portfolio for the entire period. Sector rotation holds equal weights in sectors/industries based on conventional wisdom during a particular business cycle stage. Market timing holds the market portfolio for all business cycle stages except for cash during early recession. We report Jensens alphas as annualized rates with White (1980) heteroskedasticity consistent t-statistics.

Full Period 1948:01 - 2007:12 Strategy Market 0% round-trip transaction costs Sector rotation Market-timing 0.5% round-trip transaction costs Sector rotation Market-timing 1.0% round-trip transaction costs Sector rotation Market-timing Jensen's alpha t-statistic Sharpe ratio 0.13

2.3% 2.5%

1.94 3.57

0.15 0.17

1.9% 2.3%

1.59 3.32

0.14 0.17

1.5% 2.1%

1.24 3.06

0.14 0.16

1.5% round-trip transaction cost Sector rotation 1.1% 0.89 0.13 Market-timing 1.9% 0.16 2.78 *sector rotation and market-timing have respectively 50 and 20 round-trip transactions

42

Table VI. Average statistics and performance comparison using different data sets by NBER business cycle stage Notes: Table reports the average beta, standard deviation, stage mean return, full period mean return, excess market return (mkt), Jensens alpha (J), Fama and French three-factor alpha (F), and Carhart four-factor alpha (C), and the difference between sector/industry and market Sharpe ratios for the business cycle stage considered optimal by conventional wisdom. We report annualized standard deviations, means, and alpha performance measures.
Performance Measures Sharpe Ratio J F C Difference -0.05 -0.03 0.06 0.00 -0.05 -0.03 0.03 -0.02 -0.04 -0.02 0.01 -0.02 -0.11 -0.12 0.06 0.02

Industries Early Expansion Industries - Stage I: Fama & French 48 Industries Standard & Poors 15 Sectors Fama & French 16 Sectors Fidelity Select 42 Sectors

Period 1948:01-2007:12 1948:01-2007:12 1948:01-2007:12 1981:08-2008:08

beta std. dev. 1.32 1.12 1.00 1.45 0.23 0.21 0.16 0.26

stage period mean mean 0.14 0.15 0.24 0.07 0.10 0.09 0.11 0.07

mkt -0.02 0.01 0.09 0.05

Middle Expansion Industries - Stage II: Fama & French 48 Industries 1948:01-2007:12 Standard & Poors 15 Sectors 1948:01-2007:12 Fama & French 16 Sectors 1948:01-2007:12 Fidelity Select 42 Sectors 1981:08-2008:08 Late Expansion Industries - Stage III: Fama & French 48 Industries Standard & Poors 15 Sectors Fama & French 16 Sectors Fidelity Select 42 Sectors

1.11 1.06 1.13 1.10

0.21 0.25 0.19 0.22

0.13 0.08 0.13 0.17

0.10 0.08 0.11 0.11

0.00 -0.02 0.00 -0.03

-0.01 -0.05 -0.02 -0.01

-0.03 -0.07 -0.03 0.00

-0.03 -0.06 -0.02 0.00

-0.07 -0.14 -0.06 -0.07

1948:01-2007:12 1948:01-2007:12 1948:01-2007:12 1981:08-2008:08

0.79 0.60 0.67 0.73

0.22 0.16 0.16 0.21

0.11 0.07 0.11 0.14

0.13 0.09 0.13 0.11

0.04 0.03 0.03 0.03

0.04 0.01 0.04 0.05

0.04 0.00 0.04 0.05

0.03 0.00 0.03 0.03

0.04 0.00 0.06 0.03

Early Recession Industries - Stage IV: Fama & French 48 Industries 1948:01-2007:12 Standard & Poors 15 Sectors 1948:01-2007:12 Fama & French 16 Sectors 1948:01-2007:12 Fidelity Select 42 Sectors 1981:08-2008:08 Late Recession Industries - Stage V: Fama & French 48 Industries Standard & Poors 15 Sectors Fama & French 16 Sectors Fidelity Select 42 Sectors

0.70 0.70 0.76 1.05

0.15 0.18 0.16 0.21

-0.02 -0.09 0.00 -0.15

0.11 0.05 0.11 0.07

0.17 0.16 0.22 -0.03

0.09 0.01 0.13 -0.05

0.08 -0.01 0.12 -0.02

0.08 -0.01 0.12 -0.02

0.28 0.18 0.33 0.00

1948:01-2007:12 1948:01-2007:12 1948:01-2007:12 1981:08-2008:08

1.13 0.90 1.13 1.18

0.25 0.21 0.24 0.26

0.51 0.30 0.50 0.35

0.11 0.07 0.11 0.11

0.08 -0.03 0.09 0.14

0.04 -0.05 0.03 0.12

0.01 -0.07 0.00 0.11

-0.01 -0.08 -0.01 0.09

-0.04 -0.16 -0.03 0.12

43

Table VII. Industry measures based on the CFNAI over the 1968:01-2007:12 period Notes: Panel A reports average industry statistics and performance measures by CFNAI delineated business cycle stages. We divide the range of CFNAI values into five equal stages to construct business cycles stages of 96 observations each. We report the average single index model beta, standard deviation, stage mean return, full period mean return, excess market return (mkt), Jensens alpha (J), Fama and French three-factor alpha (F), and Carhart four-factor alpha (C), and industry-market Sharpe ratio difference for all industries that based on conventional wisdom provide optimal performance during a particular business cycle stage. We report annualized standard deviations, means, and performance measures. Panel B reports regression coefficients from equation (6) and bootstrapped p-values for the likelihood that level and change of CFNAI coefficients jointly have the correct sign.
ri ,t rf t = 0 + 1CFNAI t + 2 CFNAI t + i (rmkt ,t rft ) + t

(6)

Panel A:
Performance Measures Sector/Industry Early Expansion Industries - Stage I: Middle Expansion Industries - Stage II: Late Expansion Industries - Stage III: Early Recession Industries - Stage IV: Late Recession Industries - Stage V: beta std. dev. 1.26 1.06 0.88 0.89 1.08 0.28 0.20 0.19 0.18 0.27 stage mean 0.06 0.04 0.17 0.10 0.11 sample mean 0.07 0.09 0.12 0.11 0.10 mkt -0.02 -0.01 0.01 -0.03 0.02 J -0.02 -0.01 0.02 -0.01 0.02 F -0.01 -0.03 0.01 -0.03 0.00 C 0.01 -0.03 0.00 -0.02 0.01 Sharpe ratio Difference -0.02 -0.02 -0.06 -0.08 0.01

Panel B:
Expected Sign of CFNAI regression Coefficient CFNAI Industries CFNAI pos pos Early Recession pos Late Recession pos neg CFNAI neg pos

Industries Early Expansion Middle Expansion Late Expansion

CFNAI neg neg

joint probability of regression coefficient signs CFNAI 0 (Mkt-TBL) CFNAI 0.004 -0.007 -0.001 -0.001 -0.001 -0.003 CFNAI 0.003 0.035 0.012 0.010 0.003 0.012 Stage Early Expansion Industry Computers Computer Software Electronic Equipment Measuring & Control Shipping Containers Transportation CFNAI 0 CFNAI < 0 CFNAI < 0 and and and and constant coefficient coefficient coefficient CFNAI 0 CFNAI < 0 CFNAI < 0 CFNAI 0 -0.003 -0.009 -0.003 -0.003 0.001 -0.001 1.26 1.77 1.48 1.39 0.94 1.08 0.61 0.11 0.36 0.36 0.21 0.08 0.32 0.00 0.01 0.03 0.11 0.00 0.02 0.01 0.01 0.02 0.19 0.01 0.06 0.87 0.62 0.59 0.49 0.90

44

Table VII. Continued

joint probability of regression coefficient signs CFNAI 0 (Mkt-TBL) CFNAI -0.002 0.004 -0.004 0.001 0.001 0.002 -0.002 0.000 0.002 -0.002 -0.006 -0.003 0.000 -0.005 -0.001 -0.005 -0.004 -0.009 -0.004 0.000 -0.005 0.005 -0.002 0.002 -0.007 -0.004 -0.005 -0.004 -0.010 -0.002 -0.008 -0.003 -0.004 -0.004 -0.001 -0.002 -0.008 -0.005 -0.001 -0.002 -0.002 0.002 CFNAI 0.010 0.006 0.014 0.015 0.009 0.008 0.010 0.018 0.008 0.005 0.010 0.006 0.002 -0.008 -0.015 -0.007 -0.025 0.002 -0.003 -0.013 -0.006 0.000 -0.005 -0.010 0.017 -0.005 0.012 0.003 0.018 0.009 0.018 0.003 0.022 0.007 0.007 0.012 0.004 0.008 -0.010 0.000 0.014 -0.002 Stage Industry Steel Works Precious Metals Mining Fabricated Products Machinery Electrical Equipment Aircraft Shipbuilding & Railroad Defense Personal Services Business Services Late Expansion Agriculture Food Products Candy & Soda Beer & Liquor Tobacco Products Healthcare Medical Equipment Pharmaceutical Coal Petroleum & Natural Early Recession Late Recession Utilities Communication Recreation Entertainment Printing & Publishing Consumer Goods Apparel Rubber & Plastic Textiles Construction Material Construction Automobiles & Truck Business Supplies Wholesale Retail Restaraunts & Hotels Banking Insurance Real Estate Trading CFNAI 0 CFNAI < 0 CFNAI < 0 and and and and constant coefficient coefficient coefficient CFNAI 0 CFNAI < 0 CFNAI < 0 CFNAI 0 0.000 -0.003 -0.001 0.000 -0.006 -0.001 0.002 0.000 -0.001 0.003 -0.004 -0.001 0.001 0.003 0.001 0.003 0.006 -0.001 0.002 0.002 0.002 0.003 0.002 0.000 -0.003 0.002 -0.001 0.000 0.000 0.000 0.000 0.000 -0.001 -0.002 0.000 0.000 0.001 0.001 0.001 0.002 -0.005 0.002 0.97 1.23 0.71 1.02 1.09 1.18 1.16 1.14 1.00 0.82 1.15 1.20 0.89 0.70 0.84 0.80 0.65 1.12 0.89 0.82 1.10 0.78 0.52 0.75 1.18 1.30 1.02 0.83 1.11 1.05 0.98 1.10 1.30 1.02 0.95 1.09 1.03 1.13 1.01 0.90 1.09 1.23 0.14 0.77 0.19 0.64 0.60 0.88 0.08 0.43 0.62 0.19 0.05 0.04 0.28 0.00 0.01 0.00 0.00 0.01 0.01 0.00 0.02 0.51 0.01 0.03 0.00 0.03 0.02 0.02 0.00 0.15 0.00 0.02 0.12 0.06 0.34 0.12 0.00 0.06 0.00 0.09 0.28 0.28 0.01 0.19 0.04 0.01 0.05 0.01 0.00 0.01 0.10 0.08 0.01 0.01 0.20 0.00 0.41 0.04 0.10 0.05 0.03 0.50 0.16 0.46 0.10 0.87 0.00 0.18 0.00 0.01 0.00 0.01 0.00 0.01 0.00 0.01 0.06 0.00 0.00 0.02 0.25 0.14 0.01 0.61 0.01 0.00 0.10 0.00 0.02 0.00 0.01 0.00 0.03 0.19 0.09 0.04 0.19 0.96 0.57 0.86 0.90 0.38 0.68 0.49 0.56 0.01 0.74 0.10 0.01 0.56 0.01 0.22 0.00 0.03 0.00 0.24 0.00 0.13 0.04 0.00 0.20 0.11 0.72 0.37 0.02 0.05 0.85 0.05 0.66 0.35 0.33 0.11 0.90 0.56 0.24 0.54 0.86 0.91 0.33 0.03 0.01 0.10 0.00 0.57 0.28 0.00 0.26 0.02 0.14 0.00 0.98 0.23 0.97 0.76 1.00 0.82 1.00 0.72 0.88 0.80 0.56 0.88 0.80 0.81 0.03 0.40 0.70 0.07

Middle Expansion Chemicals

45

Table VIII. Comparison of strategy performance with changes in timing the business cycle
Notes: Table reports the performance of sector rotation and market timing when we advance or delay strategy implementation from the base case by the number of months shown. The table reports Jensens alphas (J) as annualized rates with White (1980) heteroskedasticity consistent t-statistics and Sharpe ratio performance measures. Table includes market results at the bottom for comparison. The performance results shown are before transaction costs.

Full Period 1948:01 - 2007:12 Strategy implementation Sector Rotation: + 3 month + 2 month + 1 month at turning point - 1 month - 2 month - 3 month Market-timing: + 3 month + 2 month + 1 month at turning point - 1 month - 2 month - 3 month Market Jensen's alpha 1.0% 1.0% 1.9% 2.3% 2.2% 1.8% 1.5% t-statistic 0.86 0.85 1.63 1.94 1.81 1.53 1.27 Sharpe ratio 0.13 0.13 0.14 0.15 0.15 0.14 0.14

1.7% 2.6% 2.9% 2.5% 1.2% 0.9% 0.3% -

2.44 3.54 3.75 3.57 3.10 2.25 0.63 -

0.16 0.18 0.18 0.17 0.15 0.15 0.13 0.13

46

Table IX. Construction of sector rotation portfolios based on a one-period-ahead forecast model Notes: Table reports the composition of sector rotation portfolios constructed with a forecast model using business cycle variables (BCV) that the literature shows forecast stock returns over the course of business cycles. The business cycle variables comprise lagged changes in the one-month Treasury bill, term-structure, default-spread, and dividend yield. We forecast industry with parameters estimated with a regression of excess industry returns (ri,t-rf ) on a constant, lagged change in the business cycle variables (BCVi), and excess market returns (rmkt-rf) using equation 9. We estimate the (i) forecast parameters with a 60-month rolling window that moves forward each month and use these parameter estimates to obtain period ahead forecasts of industry outperformance calculated as the sum of the gamma estimates times current period changes in business cycle variables from the proceeding period. We include all industries with positive forecast outperformance in the period-ahead sector rotation portfolio. Panel A reports the average number of industries selected for inclusion during each business cycle stage. Panel B reports the percentage of time an industry has positive forecast outperformance and is thus selected for inclusion during a particular business cycle stage. We also test for any difference between the percentage of time the model selects an industry for inclusion in the portfolio and a random 50/50 probability of inclusion, with 10 percent statistical significance indicated in bold. The shaded area in Panel B represents the business cycle stage that conventional wisdom considers optimal.

ri ,t rft = c0 + i BCVi ,t 1 + (rmkt ,t rft ) + t

i =1

(7)

Panel A: Average number of industries selected for inclusion by model Full Early Middle Late Early Period Expansion Expansion Expansion Recession 23 23 23 23 22 Panel B: Percentage of time model forecasts excess industry returns and includes in sector rotation portfolio Full Early Middle Period Industries Period Expansion Expansion Early Expansion - Stage I Computers 48 48 46 Computer Software 38 38 37 Electronic Equipment 47 47 47 Measuring & Control 50 50 52 Shipping Containers 48 48 42 Transportation 49 56 46 Middle Expansion - Stage II Chemicals 50 53 49 Steel Works 54 57 56 Precious Metals 40 38 42 Mining 51 53 52 Fabricated Products 45 40 34 Machinery 48 45 56 Electrical Equipment 47 47 47 Aircraft 48 53 48 Shipbuilding & Railroad 50 48 50 Defense 40 39 41 Personal Services 48 46 52 Business Services 52 54 55

Late Recession 23

Late Expansion 43 40 47 47 54 44 46 48 40 48 44 47 45 47 54 41 47 49

Early Recession 40 38 49 43 55 51 55 43 36 51 30 45 62 36 36 36 53 36

Late Recession 48 33 50 54 46 57 46 67 43 52 39 39 43 50 54 39 43 57

47

Table IX. Continued

Panel B: Continued Period Late Expansion - Stage III Industries Agriculture Food Products Candy & Soda Beer & Liquor Tobacco Products Healthcare Medical Equipment Pharmaceutical Coal Petroleum & Natural Utilities Communication Recreation Entertainment Printing & Publishing Consumer Goods Apparel Rubber & Plastic Textiles Construction Material Construction Automobiles & Truck Business Supplies Wholesale Retail Restaraunts & Hotels Banking Insurance Real Estate Trading Full Period 53 49 39 49 49 32 48 51 49 52 47 51 48 46 48 48 52 50 49 48 49 52 50 49 48 50 51 50 51 53 Early Expansion 53 48 33 49 47 31 40 45 47 54 39 45 55 47 51 48 55 60 57 49 51 56 55 50 45 52 44 41 56 51 Middle Expansion 57 46 38 45 47 37 49 49 49 51 48 57 43 48 48 47 51 48 47 42 49 49 51 52 48 53 52 55 52 58 Late Expansion 51 52 43 50 54 34 57 57 49 51 52 52 47 42 48 45 52 48 46 49 50 53 45 45 48 44 57 56 49 51 Early Recession 53 49 53 60 49 21 53 57 64 51 55 55 36 43 36 51 45 40 40 47 40 43 49 51 57 49 53 55 36 49 Late Recession 52 52 33 50 52 22 37 48 41 59 48 52 52 57 43 54 50 39 43 54 48 54 46 48 48 57 46 37 54 54

Early Recession - Stage IV Late Recession - Stage V

48

Table X. Alternative sector rotation strategy Notes: Table reports the performance of industries that over the 19482007 period provided statistically significant outperformance for the indicated business cycle stage. Column 3 reports the percentage of time (%) that that an industry actually realized statistically significant Jensens alpha outperformance. We test the percentage of time an industry actually provides outperformance against a random 50/50 chance with 10 percent statistical significance indicated in bold. Column 4 reports annualized Jensens alpha estimates while column 5 reports the Jensens alpha White (1980) heteroskedasticity consistent t-statistics highlighted for statistical significance at 10 percent.
J 0.10 0.07 0.08 0.09 0.10 0.13 0.13 0.20 0.15 0.16 0.17

Period Sector/Industries Middle Expansion - Stage II Candy & Soda Pharmaceutical Late Expansion - Stage III Mining Tobacco Products Early Recession - Stage IV Shipping Containers Food Products Utilities Entertainment Late Recession - Stage V Personal Services Food Products Tobacco Products

% 62 55 53 59 62 72 66 66 71 69 61

t-statistic 2.51 2.35 2.14 1.83 2.42 2.12 2.45 2.71 2.06 2.78 1.75

49

Figure I. Conventional Wisdom: Sector Rotation across the Business Cycle

Source: http://personal.fidelity.com/products/funds/content/sector/cycle.shtml

Source: http://www.marketoracle.co.uk/Article3618.html

Source: http://www2.standardandpoors.com/spf/pdf/index/Global_Sector_Investing.pdf

50

Figure II. Stylized business cycles with stage partitions

Notes: Figure illustrates a stylized economic business cycle. The official government agency responsible for dating U.S. business cycles is the National Bureau of Economic Research (NBER). The NBER publishes dates for business cycle peaks and troughs. We measure phases of expansion from trough to peak and recession from peak to trough. Similar to Stovall (1996), we divide expansions into three equal stages (early/middle/late) and recessions into two stages (early/late).

NBER peak Expansion

Stage I Stage II Stage III

Recession
Stage IV StageV

NBER trough

NBER trough

Stages of Expansion Early Expansion - Stage I Middle Expansion - Stage II Late Expansion - Stage III

Stages of Recession Early Recession - Stage IV Late Recession - Stage V

51

Figure III. CFNAI business cycle stages

Notes: Figure illustrates the CFNAI economic indicator over the period 19682007. Shaded areas indicate NBER defined periods of economic contraction. The range of CFNAI values covering the full sample are partitioned into 5 equal periods of economic activity that can be thought of as corresponding to periods of early expansion (SI), middle expansion (SII), late expansion (SIII), early recession (SIV), and late recession (SV). The partitions between adjoining stages are shown with delineations at CFNAI values of 0.57, 0.26, -.01, and -.045 between periods SI|SII, SII|SIII, SIII|SIV, and SIV|SV respectively.

2.5

1.5

0.5

1968 -0.5

1974

1979

1985

1990

1996

2001

2007

-1.5

-2.5

-3.5

-4.5 NBER Recessions S1|S2 S2|S3 S3|S4 S4|S5 CFNAI

52

Figure IV. Distribution of Jensens alphas of sectors in different stages Note: Chart illustrates the actual percentage of time that industry Jensens alpha t-statistics fall within the indicated range and compares with the expected distribution of t-statistics under a normal distribution. We calculate Jensens alphas for each industry during each business cycle for a total of 240 corresponding t-statistics.

20% 18% 16% 14%

Frequency

12% 10% 8% 6% 4% 2% 0%

< 3.29

3.29to2.58

2.58to1.96

1.96to1.65

1.65 to1

1 to0.5

0.5to0

0 to0.5

0.5to1

1 to1.65

1.65 to1.96

1.96 to2.58

2.58 to3.29

TStatistic Range

Actualdistribution ofJensen'salpha tstatistics

Expecteddistribution ofJensen'salpha tstatistics assuming a normaldistribution

53

> 3.29