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Sector Rotation for Dummies

Monday, 19 Mar 2007 | 6:49 PM ET

Spotting a sector rotation, when money moves from one sector or group of sectors into another because of the business cycle, is of the utmost importance. As far as Cramer is concerned, it’s one of the key moves you need to spot before it happens if you want to make money in the market.

Fifty percent of how a stock moves depends upon the performance of the sector it's in. So if you can call the sector, you can call half the gains or losses in a given stock. Why is this true? Because most of the big fund managers are committed to sector-based thinking, and they're the buyers and sellers who set prices.

You've got two kinds of companies out there. Cyclical businesses do well when the economy is growing fast, when the Fed has rates low, but they don't do so well when the economy slows down. These are airlines, autos, raw materials, consumer durables, heavy equipment, that kind of thing.

Secular stocks aren't sensitive to the underlying strength or weakness of the economy. General Mills, Procter & Gamble, Johnson & Johnson, any of the utilities. They won't be affected by the cycle because we don't stop buying Band-Aids just because we're low on cash.

This is how you play the cycles: At the top of the cycle, before you think a downturn is coming, maybe because the Fed is raising rates, you load up on your secular stocks. At the bottom, you swap out of all that for some beaten up cyclicals. Just so you get this, let’s repeat: When the economy is humming along with high growth, you sell cyclicals and buy secular stocks. When our GDP growth is in the gutter, but you think it’s done going down, that’s the time to load up on cyclicals.

The reason this is actually difficult is that it's very counter-intuitive. When cyclical stocks start to bottom, everyone cuts their earnings estimates for them. Remember, this is the bottom of the cycle so the companies are suffering. The estimates get slashed, but the company has hit bottom. It won't go much lower. That makes these stocks look expensive, because it's not the price we care about, it's the price-to-earnings multiple. When these companies are at their most "expensive" at the bottom of the cycle, you have to buy. You buy because you know that their earnings are going to increase as the economy picks up, and you'll never be able to buy them so low after we get a little steam.

Bottom Line: Play defense, buy secular stocks at the top of the cycle, and go on offense with cyclicals when the economy is so bad that you need to take away the tie and the shoelaces.

Questions? Comments? madmoney@cnbc.com

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