Professional Documents
Culture Documents
Ben Jacobsen1
Jeffrey Stangl2
Nuttawat Visaltanachoti3
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.
1
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.
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.
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 Fidelity’s view on when specific sectors
should perform well over the business cycle. Standard & Poor’s and the website
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
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
http://personal.fidelity.com/products/funds/content/sector/cycle.shtml
5
Reuters (2008)
6
CNN Money (2006)
7
Business Week Online (2002)
3
“... 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
In our perfect scenario, the evidence favors sector rotation, but only marginally so. Our
base case covers the 1948–2007 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
8
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.
4
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, default-
spread, 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
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
Jensen’s 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 & Poor’s sector indices, Fama and French sectors, and Fidelity Sector Select
funds; these different data sets and partitions still leave our main result intact.
5
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
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
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 & Poor’s 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
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
6
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 study’s 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
rotation—at 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
9
July 2009.
10
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).
7
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)
8
2. Business Cycles
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
15
See for example Chatterjee (1999) and Cover and Pecorino (2005)
16
For a survey of business cycle dating methodologies see Chauvet and Hamilton (2005)
9
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
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
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
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
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
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
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 short-
term interest rates combined with precious metals prices.
11
3.3. Nominal industry performance
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
stage and report our results, along with some additional descriptive statistics, in Table III.
5
ri , t = ∑μ
s =1
i,s D s ,t + ε 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 μi,s coefficients measure nominal industry returns
for each of the five stages. For brevity, Table III reports industry results only for the stage
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
We compare industry returns with market returns during each stage of expected
during the months of early expansion. The transportation industry thus provides
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
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
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
We next calculate the difference between industry and market Sharpe ratios, excess market
returns, Jensen’s 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
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 p-
values 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
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
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 αmkt is
5
ri ,t − rmkt ,t = ∑α mkt ,i ,s Ds ,t + ε t (2)
s =1
Additionally, we report Jensen’s alphas that we estimate for each stage of the business
5 5
ri , t − rf t = ∑α
s =1
J ,i , s D s ,t + ∑β
s =1
1, i , s ( rm kt , t − rf t ) D s , t + ε 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 (αF) 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 (αC) with a modified four-factor
model that adds an additional momentum factor to the Fama and French three-factor model.
maintains. These results strengthen our earlier findings for nominal returns. Based on Jensen’s
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
As an additional step, we test for differences in market outperformance across the five
business cycle stages (αmkt) using a Wald test. We report p-values in Table IV under a null
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
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.
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
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
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
22
Since we estimate Jensen’s 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
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 & Poor’s sector indices, the
Fama and French sectors, and the Fidelity Sector Select funds.
19
The Standard & Poor’s indices provide a benchmark of sector performance frequently used
by practitioners. There are a number of Standard & Poor’s indices. We use the 15 Standard &
Poor’s indices available from Global Financial Data for the entire 1948–2007 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.
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
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.
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
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.
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
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
For brevity, we report industry averages by business cycle stage and provide complete results upon request.
29
For Steel Works (Middle Expansion) the joint probability that significant outperformance occurs in expansion
is statistically significant.
23
Please insert Table VIII around here.
further in advance of NBER business cycle stage turning points. The sector rotation Jensen’s
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.
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
We create a forecast model using the one-month Treasury bill, term-spread,31 default-
spread,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
30
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.
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 (ΔBCV),
4
ri ,t − rft = c0 + ∑ γ i ΔBCVi ,t −1 + β (rmkt ,t − rft ) + ε t (7)
i =1
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 (γi) obtained from changes in
the business cycle variables to forecast one period ahead Jensen’s alpha, where we decompose
Jensen’s alpha to allow for the contribution of business cycle determinants to industry
window to estimate the (γi) forecast parameters. The rolling window moves forward each
month to obtain γi estimates from the most recent 60-month window. We then use the
month (αˆ J ,t +1 ) measured with equation 8 as the sum of the gamma estimates times changes in
4
current business cycle variable values from the proceeding period (∑ λˆi ΔBCVt ) . Each month
i =1
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
4
αˆ J ,t +1 = ∑ λˆi ΔBCVt (8)
i =1
To clarify with an example, in month 61 we first estimate the γi parameters with month 1 to
month 60 data. We next multiply the γi parameter estimates by ΔBCVi,61 measured as the
4
determinants. Lastly, we select all industries where ∑ λˆ ΔBCV
i =1
i t > 0 for inclusion in a sector
rotation portfolio for a one-month holding period. The following month, we move the rolling
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
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):
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.
Next, we investigate the connection between industry outperformance and these same
2
ri ,t − rf t = α 0 + ∑ D p ⎡⎣ β BCP , p BCPj ,t + β mkt , p (rmkt ,t − rf t ) ⎤⎦ + ε t (9)
p =1
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 βBCP 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) βterm-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
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.
As the Standard and Poor’s graph in Figure I shows, the outperformance of Technology
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 Jensen’s 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
5.6.5. Sub-samples
Significant events over a full 60-year sample period, like the 1970’s bear market and the
1990’s dotcom market could overly influence our results. We compare average performance
measures for each stage for the 1948–1977 and 1978–2007 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, market-
timing, and buy-and-hold strategies. The Goetzmann, Ingersoll, Spiegel and Welch (2007)
performance measure eliminates any bias in Sharpe ratio or Jensen’s alpha measures of
and Donald (2003) stochastic dominance test provides a test of strategy performance
independent of asset pricing benchmarks. Even allowing for such considerations, different
So far, we find little evidence in favor of sector rotation based on mainstream conventional
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
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 Jensen’s 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 Jensen’s, 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
recession; and Personal Services, Food Products and once more Tobacco Products in late
recession.
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 60–70 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
1948–1977 and 1978–2007 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
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,
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
33
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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.
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.
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.
5
ri ,t = ∑ μi ,s Ds ,t + ε t (1)
s =1
38
Table III. Continued
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
(αmkt), Jensen’s alphas (αJ), Fama and French (1992) three-factor alphas (αF), and Carhart (1997) four-
factor alphas (αC) 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 one-
month 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, Jensen’s alphas, Fama and French alphas, and Carhart alphas by business cycle stage with
equations 2–5 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.
5
ri ,t − rmkt ,t = ∑α mkt ,i ,s Ds ,t + ε t (2)
s =1
5 5
ri ,t − rft = ∑ α J ,i , s Ds ,t + ∑ β1,i , s (rmkt ,t − rft ) Ds ,t + ε t (3)
s =1 s =1
5 5
ri ,t − rft = ∑ α F ,i , s Ds ,t + ∑ ⎡⎣ β1,i , s (rmkt ,t − rft ) + β 2,i , s SMBt + β3,i , s HMLt ⎤⎦ Ds ,t + ε t (4)
s =1 s =1
5 5
ri ,t − rft = ∑ α C ,i , s Ds ,t + ∑ ⎡⎣ β1,i , s (rmkt ,t − rft ) + β 2,i , s SMBt + β3,i , s HMLt + β 4,i , s MOM t ⎤⎦ Ds ,t + ε t (5)
s =1 s =1
40
Table IV. Continued
41
Table V. Comparison of market, sector rotation, and market timing performance
Notes: Table compares Jensen’s 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
Jensen’s alphas as annualized rates with White (1980) heteroskedasticity consistent t-statistics.
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 (αmkt), Jensen’s alpha (αJ), Fama and French three-factor alpha
(αF), and Carhart four-factor alpha (αC), 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
stage period Sharpe Ratio
Industries Period beta std. dev. mean mean α mkt αJ αF α C Difference
Early Expansion Industries - Stage I:
Fama & French 48 Industries 1948:01-2007:12 1.32 0.23 0.14 0.10 -0.02 -0.05 -0.05 -0.04 -0.11
Standard & Poors 15 Sectors 1948:01-2007:12 1.12 0.21 0.15 0.09 0.01 -0.03 -0.03 -0.02 -0.12
Fama & French 16 Sectors 1948:01-2007:12 1.00 0.16 0.24 0.11 0.09 0.06 0.03 0.01 0.06
Fidelity Select 42 Sectors 1981:08-2008:08 1.45 0.26 0.07 0.07 0.05 0.00 -0.02 -0.02 0.02
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 (αmkt), Jensen’s alpha (αJ), Fama and French three-factor alpha (αF), and
Carhart four-factor alpha (αC), 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.
Panel A:
Performance Measures
stage sample Sharpe ratio
Sector/Industry beta std. dev. mean mean α mkt αJ αF αC Difference
Early Expansion Industries - Stage I: 1.26 0.28 0.06 0.07 -0.02 -0.02 -0.01 0.01 -0.02
Middle Expansion Industries - Stage II: 1.06 0.20 0.04 0.09 -0.01 -0.01 -0.03 -0.03 -0.02
Late Expansion Industries - Stage III: 0.88 0.19 0.17 0.12 0.01 0.02 0.01 0.00 -0.06
Early Recession Industries - Stage IV: 0.89 0.18 0.10 0.11 -0.03 -0.01 -0.03 -0.02 -0.08
Late Recession Industries - Stage V: 1.08 0.27 0.11 0.10 0.02 0.02 0.00 0.01 0.01
Panel B:
44
Table VII. Continued
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
Jensen’s alphas (αJ) 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.
Market-timing:
+ 3 month 1.7% 2.44 0.16
+ 2 month 2.6% 3.54 0.18
+ 1 month 2.9% 3.75 0.18
at turning point 2.5% 3.57 0.17
- 1 month 1.2% 3.10 0.15
- 2 month 0.9% 2.25 0.15
- 3 month 0.3% 0.63 0.13
Market - - 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 (ΔBCVi), and excess market returns
(rmkt-rf) using equation 9. We estimate the (γi) 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.
4
ri ,t − rft = c0 + ∑ γ i ΔBCVi ,t −1 + β (rmkt ,t − rft ) + ε t (7)
i =1
Panel B: Percentage of time model forecasts excess industry returns and includes in sector rotation portfolio
Full Early Middle Late Early Late
Period Industries Period Expansion Expansion Expansion Recession Recession
Early Expansion - Stage I Computers 46 48 48 43 40 48
Computer Software 38 38 37 40 38 33
Electronic Equipment 47 47 47 47 49 50
Measuring & Control 50 50 52 47 43 54
Shipping Containers 48 48 42 54 55 46
Transportation 49 56 46 44 51 57
Middle Expansion - Stage II Chemicals 50 53 49 46 55 46
Steel Works 54 57 56 48 43 67
Precious Metals 40 38 42 40 36 43
Mining 51 53 52 48 51 52
Fabricated Products 40 34 45 44 30 39
Machinery 48 56 45 47 45 39
Electrical Equipment 47 47 47 45 62 43
Aircraft 48 53 48 47 36 50
Shipbuilding & Railroad 50 48 50 54 36 54
Defense 40 39 41 41 36 39
Personal Services 48 46 52 47 53 43
Business Services 52 54 55 49 36 57
47
Table IX. Continued
Panel B: Continued
Full Early Middle Late Early Late
Period Industries Period Expansion Expansion Expansion Recession Recession
Late Expansion - Stage III Agriculture 53 53 57 51 53 52
Food Products 49 48 46 52 49 52
Candy & Soda 39 33 38 43 53 33
Beer & Liquor 49 49 45 50 60 50
Tobacco Products 49 47 47 54 49 52
Healthcare 32 31 37 34 21 22
Medical Equipment 48 40 49 57 53 37
Pharmaceutical 51 45 49 57 57 48
Coal 49 47 49 49 64 41
Petroleum & Natural 52 54 51 51 51 59
Early Recession - Stage IV Utilities 47 39 48 52 55 48
Communication 51 45 57 52 55 52
Late Recession - Stage V Recreation 48 55 43 47 36 52
Entertainment 46 47 48 42 43 57
Printing & Publishing 48 51 48 48 36 43
Consumer Goods 48 48 47 45 51 54
Apparel 52 55 51 52 45 50
Rubber & Plastic 50 60 48 48 40 39
Textiles 49 57 47 46 40 43
Construction Material 48 49 42 49 47 54
Construction 49 51 49 50 40 48
Automobiles & Truck 52 56 49 53 43 54
Business Supplies 50 55 51 45 49 46
Wholesale 49 50 52 45 51 48
Retail 48 45 48 48 57 48
Restaraunts & Hotels 50 52 53 44 49 57
Banking 51 44 52 57 53 46
Insurance 50 41 55 56 55 37
Real Estate 51 56 52 49 36 54
Trading 53 51 58 51 49 54
48
Table X. Alternative sector rotation strategy
Notes: Table reports the performance of industries that over the 1948–2007 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 Jensen’s 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 Jensen’s alpha estimates while
column 5 reports the Jensen’s alpha White (1980) heteroskedasticity consistent t-statistics
highlighted for statistical significance at 10 percent.
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 Recession
51
Figure III. CFNAI business cycle stages
Notes: Figure illustrates the CFNAI economic indicator over the period 1968–2007. 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
-1.5
-2.5
-3.5
-4.5
52
Figure IV. Distribution of Jensen’s alphas of sectors in different stages
Note: Chart illustrates the actual percentage of time that industry Jensen’s alpha t-statistics
fall within the indicated range and compares with the expected distribution of t-statistics under
a normal distribution. We calculate Jensen’s 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
‐3.29 to ‐2.58
‐2.58 to ‐1.96
‐1.96 to ‐1.65
‐1.65 to ‐1
‐1 to ‐0.5
‐0.5 to 0
0 to 0.5
0.5 to 1
1 to 1.65
1.65 to 1.96
1.96 to 2.58
2.58 to 3.29
> 3.29
T‐Statistic Range
53