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Understanding Sector Rotation: Technical Analysis 101

BALTIMORE (Stockpickr) -- You rotate your tires. Farmers rotate their crops. And smart investors rotate the names in their portfolios. Do you?

Asset rotation is one of the most powerful tools you can put into your investing arsenal, so it figures that it's also one of the most misunderstood.

As an investor, the idea of sector rotation sounds simple enough: It's the practice of shifting allocations from one sector to another to beat the broad market. But while describing sector rotation is simple enough, implementing a sector rotation strategy for your own portfolio is a whole different story. In this technical primer, we'll take a look at how sector rotation works and how you can tell when it's time to rotate your own investment mix.

To start, "sector rotation" really isn't the best term to describe what we're doing here.

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While the term gained popularity among mutual fund managers, who were locked into stocks by their funds' restrictions, rotation is by no means limited to the stock market. Instead, sector rotation can really be applied to all asset classes, including bonds, commodities and even cash.

So while "asset class rotation" is probably a better term, we'll stick with the regularly accepted nomenclature for the time being.

One of the keys to sector rotation is the idea that all markets (or asset classes) are connected. That's not some sort of new-age concept -- rather, it has a lot to do with the flow of funds from investors to the marketplace and with aggregate supply and demand. It's important to remember that investors' resources are finite. That means that investors have to make a choice about where they plant their assets; capital flowing into one asset class (such as stocks) generally means that capital is flowing out of another (such as cash deposits). It's that relationship that's core to sector rotation.

Understanding Broad Market Relationships

To know how to rotate between assets, it's necessary to be a little more familiar with how the relationships between different markets (known as intermarket relationships) work. The simple version breaks the market down into three markets: bonds (or interest rates), stocks and commodities.

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