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Sector Rotation for Dummies

Thursday, 30 Aug 2007 | 11:22 AM 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, Cramer said. As far as he's concerned, it’s one of the key moves investors need to spot before it happens if they want to make money in the market.

Sector Rotations
Mad Money's Jim Cramer tells you how to stay ahead of the curve.

Fifty percent of how a stock moves depends upon the performance of the sector it's in, Cramer said. So if investors can call the sector, they 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.

There are 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, Cramer said. These are the airlines, autos, raw materials, consumer durables and heavy equipment stocks.

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

Here's how to play the cycles: At the top of the cycle, before a downturn is coming, maybe because the Fed is raising rates, load up on your secular stocks, Cramer said. At the bottom, swap out of all that for some beaten up cyclicals. In a nutshell: When the economy is humming along with high growth, sell cyclicals and buy secular stocks. When GDP growth is in the gutter, but it looks like 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, Cramer said. When cyclical stocks start to bottom, everyone cuts the 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 probably won't go much lower. That makes these stocks look expensive, because it's not the price that matters, the price-to-earnings multiple does. When these companies are at their most "expensive" at the bottom of the cycle, Cramer recommends buying. Why? Because the companies' earnings are going to increase as the economy picks up, and investors will never be able to buy them so low after the market gains a little traction.

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 people need to take away the tie and the shoelaces.

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