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Understanding Sector Rotation: Technical Analysis Primer

BALTIMORE ( Stockpickr) -- As an investor, the idea of sector rotation sounds simple enough: It's the practice of portfolio managers shifting their 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 phrase to describe what we're doing here. While the term gained popularity among mutual fund managers, who were locked into stocks by their funds' restrictions, asset rotation is hardly limited to the stock market. Instead, asset rotation can really be applied to all asset classes, including bonds, commodities and even cash.

Related: Does Technical Trading Really Work?

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 -- instead, 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.

Generally, bonds lead stocks, and stocks lead commodities.

In other words, a typical investment cycle consists of a bond rally, which is followed by a stock rally, which is then followed by a commodity rally. The opposite is true as well -- weakness in bonds generally precedes weakness in stocks, which in turn precedes weakness in commodities. Not surprisingly, these relationships are due in large part to the causality between these different markets. In this cycle, for instance, stocks are in the middle of their declining phase as rallying commodities put the squeeze on margins.

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