One of the drivers behind the market’s continued climb is sector rotation. It’s been on full display over the past two trading sessions and is one of the reasons why I’ve remained bullish on the market despite heavy selling from the tech sector.

In today’s article, I’m breaking down the concept of sector rotation.

Market Organization

The stock market is comprised of thousands of publicly traded companies. Tracking the lot of them can quickly become overwhelming. Smart traders focus on the structure of the market and use shortcuts to better spot where money is flowing.

A sector is a group of similar companies. Exxon Mobil, Chevron, and Halliburton belong in the energy sector. Apple, Microsoft, and Intel call the technology sector home. Bank of America, Citigroup, and JPMorgan Chase are all part of the financial sector. So on and so forth.

The classification structure that we use breaks the market into 11 sectors. You see them every week in the gridiron portion of our Tackle Newsletter.

In general, we look to buy strong stocks in strong sectors. If you’re a bear, then you’d look for weak stocks in weak sectors. When you think about it, we’re essentially betting on trend continuation. This has worked very well for those focusing on buying tech stocks because of that sector’s strength. The same goes for avoiding purchasing energy stocks because they’ve been locked in a lagging sector.

Now, here’s where sector rotation comes in.

The Lifeblood of a Bull Market

Sector rotation is the lifeblood of a bull market. It’s what allows the S&P 500 to continue chugging along month after month, potentially without suffering a significant correction.

The S&P 500 is nothing more than the sum of its parts. If all eleven sectors are rising, then you better believe the Index will be moving higher. The same goes for if all sectors are falling.

Now, what happens if half the sectors are rising 1% and half are falling 1%? The S&P 500 would probably be flat on the session.

Here’s where sector rotation comes in.

Not all market selloffs are created equal. The benign (and preferred!) kind is a byproduct of sector rotation. Think of them as a shuffling of the deck or a rotation of capital. In contrast, the malignant selloffs are a byproduct of widespread distribution. They signal a mass exodus or departure where money is fleeing all sectors.

The past two market sessions (Friday and Monday) are illustrative. Technology has been the indisputable leader of the post-coronavirus market. But we’ve seen profit-taking strike the sector recently. It’s always concerning when the Generals get taken out and shot. There was a chance that the downturn could have seeped into all other areas and dragged the market lower. But did it?

Nope!

While technology finally pulled back, other sectors picked up the slack. We saw leaders lag and laggards lead. Banks, industrials, metals, and energy were hot. Were I to pick one chart to show the rotation, it would be the small-cap laden Russell 2000 Index. As soon as tech started to drop, the RUT caught fire.

So What’s It Mean?

How can this be anything but bullish? It showed that participants were more than happy to chase other sectors once tech finally cooled. It showed that buying interest is broadening, that market breadth is expanding.

This is the best kind of bull market. Setups are multiplying like rabbits. What more could we ask for?

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