Market Rotations
Stock markets wax and wane as investors move their money into and out of not only the markets themselves but also the sectors within those markets. Investors forever seek the most profitable investments and, when they identify an opportunity to make a better return than they could have from whatever is currently tying up their capital, they are understandably fickle.
The law of supply and demand operates as opportunists drift from one investment to another. As demand for an attractive investment increases, more funds are pulled towards it so that its value increases but its supply, its availability, decreases. In extremis would-be investors who are slow to identify the opportunity might find it next-to-impossible to participate in the boom for love or money.
Meanwhile this is often balanced by the decline in interest in other investments. There you can observe a loss of value that pushes participants out of the investment. Demand declines so supply of the unattractive commodity increases. In extremis it may be almost impossible to give away such an investment opportunity.
It is these fluctuations in supply and demand, the interminable push and pull, which cause the ebb and flow of prices in the stock market.
The dynamic influences of supply and demand are clearly demonstrated by two types of investment rotation:
There is no reason why investors should limit themselves to stocks when they can invest in bonds, commodities, property and more. Participation in two or more such markets is known as diversification. To make a decision on where to put their money, investors will assess potential returns alongside the risks of participation. The former must outweigh the latter for investors to make prudent investments. But, in essence, diversification is in itself prudent.
Investors tend to freely move their money back and forth between the stock and bond markets and, indeed, most investors diversify by having money in both of these markets at the same time. This is because bonds and stocks compliment each other within a portfolio with bonds offering security, stability, regular interest payments and guaranteed returns whilst shares offer less security but potentially greater returns.
These diversified investors have two main concerns:
- What proportion of their funds to keep in each market
- When to readjust their allocations.
When markets perform well, when economies grow and investors are optimistic, the stock markets are buoyant and therefore investors tend to rely less on bonds and more on stocks. This influx of cash raises demand for stocks that boosts their value. However, when financial markets under-perform, when economies stagnate and shrink so that investors are pessimistic, there is a flight from stocks and into bonds to protect investment capital. This influx of cash raises demand for bonds that, in turn, enhances their value.
Accurately identifying the market cycles when stock demand increases, and likewise spotting those cycles when bond demand increases, makes for profitable trading. Indeed, when demand shifts from bonds to stocks, and stocks subsequently put on value, you can profit from either:
- Buying indexed ETFs that should appreciate as stocks gain ground
- Selling bond ETFs that should depreciate as bonds lose ground
Alternatively when demand shifts from stocks to bonds, and bonds subsequently put on value, you can profit from either:
- Buying bond ETFs that should appreciate as bonds gain ground
- Selling indexed ETFs that should depreciate as stocks lose ground
You should remember that in some conditions bonds and stocks can simultaneously increase or decrease in parallel. However, historically they tend to move in opposite directions.
Stocks with similar characteristics are grouped together into market sectors, so companies operating within the healthcare sector are not on the same playing-field as those that manufacture microprocessors and which are therefore in the technology sector. Sector groupings are helpful because companies operating in similar industries tend to be driven by the self-same market and economic forces - forces that tend to mean that the companies' shares move in unison.
Knowing that a market sector's stocks should move together can inspire investment decisions because once one stock within a sector moves there is a likelihood that other stocks within that sector will likewise move as a consequence of the same forces. This field-dependence gives you opportunities to identify suitable investments within the same categories and capitalize on them.
Invariably some sectors will outperform others, and will therefore become a temporary focus of attention, but it is rare for every sector to simultaneously move either up or down.
The self-same forces of supply and demand, those which drive price movement within market sectors, also drive investors to shuttle their money between stocks and bonds. When a sector overcomes its inertia investors will turn to it. Increasing popularity, burgeoning demand and an influx of cash usually then inject momentum into the share price.
On the flip-side the same investors who are fuelling one share or sector's boom are decamping from less-popular avenues of opportunity where, as shares are dumped because demand decreases, the increased supply is detrimental to their value.
Accurately anticipating increased or decreased demand for shares in the sectors they occupy can clearly contribute to the likelihood of your making profitable trades.
When demand shifts sector, when stocks in popular sectors gain value whilst stocks in their unpopular counterparts lose value, profitability lies in any of the following:
- Buying ETFs that represent sectors experiencing an upsurge in popularity
- Buying individual stocks within sectors experiencing an upsurge in popularity
- Selling ETFs that represent sectors experiencing a downswing in popularity
- Selling individual stocks within sectors experiencing a downswing in popularity
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