Our models start with the assumptions illustrated in the Business Cycle and Intermarket sections where we demonstrate the presence of different phases (stages) in the economy. Our back testing results on Bonds, Stocks and Commodities proves that the three different assets perform differently at different stages of the Business Cycle/Intermarket model.

If the Business Cycle impacts the financial markets then different sectors/industries of the economy should perform differently at different stages of the cycle. For example, during early stages of the economic recovery when there are low interest rates, any form of business based on money borrowing (large indebtedness) will benefit.

The present value of any project calculated when interest rates are lower will be more valuable than when rates are higher, i.e. at the end of the cycle, and at the end of the expansion phase higher inflation will hurt most interest rate sensitive sectors. On the other hand, if during the latter part of the Business Cycle there is an increasing demand for commodities then commodity related business will benefit.

We could list numerous examples of how interest rates, commodity prices and inflation impact the sectors/industries of the economy, but this is not part of our research.

Sector and Industry classification

There are a number of ways to classify sectors. Standard & Poor’s (S&P) and Morgan Stanley Capital International (MSCI), two leading providers of global indices jointly launched the Global Industry Classification Standard (GICS®) in 1999. On the other hand, Dow Jones Indexes and FTSE have created a definitive classification system called the Industry Classification Benchmark (ICB). Also the Standard Industrial Classification (SIC) is used to classify business by the type of economic activity in which they are engaged. Figure 6.1 and 6.2 show what the GICS and ICB’s representation of the U.S. and global the equity markets are.

Figure 6.1: S&P and MSCI’s Global Industry Classification Standard (GICS®)

Figure 6.2:  Dow Jones Indexes and FTSE’s Industry Classification Benchmark (ICB)

Our work on sector investing

We have focused our research/modelling using three sets of data. The S&P GICS indexes (from 1942, and partially rebuilt), the Barron’s Industry indexes (from 1936 to 2004 and now Dow Jones indexes) and a set of data provided by Prof. Kennet R. French (from CRSP/Compustat) which covers US sectors and industries (total returns in this case) based on their four-digit SIC code from 1926.Our research has theorized a principle, the impact of the Intermarket correlations on the economy, and we have applied it in our modelling.

The results are impressive and it is clear that the Business Cycle and the Intermarket correlations impact business activity and investors’ expectations.In our research we have used the same principles shown in the Business Cycle and Intermarket sections and we have found that there are recurring patterns in the performance of the sectors/industries. Not all the sectors/industries performed in the same manner in the long-term which suggests that the economy does not follow a strict mechanical pattern and that human activity changes over time as well as human preferences and needs.However, our results are consistent all along the time series and the performance and the volatility achieved with our portfolio simulation are superior to a buy and hold strategy which will never pay as much as our sector rotation strategy.

Figure 6.3: Business Cycle model and Sector performance

Figure 6.4: Intermarket Model and Sector performance