What is capital rotation?
Capital rotation is the movement of money from one sector to another. But it is not just limited to the stock market, it can also mean money moving from a sector to a whole other asset class (for example from stocks to bonds), or even from one region of the world to another (for example U.S. stocks to foreign stocks).
Investors around the globe don’t like to leave money idling by, so as they sell-off one asset, they usually find somewhere else to deploy that capital.
Real life application:
If oil prices spike for an ongoing period, it usually leads to more revenue and profits for oil companies such as Exxon, Chevron, and others. During this period, we may see capital moving out of consumer discretionary stocks Consumer discretionary stocks are names like Nike, Lululemon, Disney…etc. These are companies that sell products that are “optional” to buy, not necessities or staples.
Why would this happen?
If oil prices rise, it will cost consumers more to fill up gas, therefore eating away at their ability to spend on discretionary items. This is a domino effect that hurts industries like airlines, retail, entertainment, and restaurants.
Conversely, when oil falls, money begins to rotate out of energy stocks and back to discretionary stocks.
Keep in mind that this is not an overnight situation and it doesn’t happen based on short-term data. Oil may spike for a single day and pullback so don’t be quick to rotate capital based on single day or even single week events. Prices must remain elevated for a while for the impact to actually be felt by consumers and businesses.
The Economic Cycle & Sector Rotation
There are four phases to an economic cycle
- Early expansion - this is the first stage after a recession or a hard economic period. We usually see low interest rates during this period, which leads to consumer spending and business expansion. The winners during this period are cyclicals like consumer discretionary, industrial, financial, and tech stocks.
- Mid-cycle - this is a period of strong GDP growth as a result of low interest rates and encouraged spending. Corporate profits begin to expand and inflation begins to rise as demand grows. The winners during this period are still consumer discretionary stocks, with a big focus on technology and industrials.
- Late cycle - this is what we see in late 2021-2022. Inflation begins to rapidly rise and the central bank is forced to hike interest rates. Consumer spending slows, leading to slower growth and lower corporate profits. Capital moves out of overextended names - discretionary, tech, materials - and back to defensive (and sometimes energy). Defensive stocks would be names in utilities, healthcare, and consumer staples.
- Recession - this is the final phase of the economic cycle (unless there’s a depression). GDP usually contracts, leading to higher unemployment and weaker consumer spending. Capital usually stays in defensive names during this period.
None of these examples are exact blueprints, they simply reflect how investors have historically shifted capital during different phases of the economic cycle. Because the economy has countless moving parts, no two scenarios ever play out the same way. These cycles are useful to keep in mind, but investors should also remain flexible and combine them with real-time data and market signals
Please note - capital can rotate between stocks, bonds, commodities, and even to cash. All depends on the situation and data.