Cramer breaks down market rotations and what they mean for investors

  • CNBC's Jim Cramer digs into the concept of sector rotations and explains how investors can use them to refine their portfolios.
  • The "Mad Money" host uses the stocks of 3M and Facebook to detail a good rotation-day exercise for investors.

CNBC's Jim Cramer is all too familiar with the fact that even the best stocks don't go up in a straight line.

So as the tech sector weighed down the Nasdaq and S&P 500 on Wednesday, the "Mad Money" host went over the concept of rotations — when investors swap out of one stock group and into another — and how homegamers can use them to their advantage.

First, he pointed out that sector rotations are inevitable. No one stock group can soar endlessly without running into obstacles, even if those obstacles have little to do with what drives the stocks themselves.

For example, the tech-heavy Nasdaq has climbed nearly 16 percent since the start of 2018 — better than any other major index in the world — thanks to the strength of FANG, Cramer's acronym for the stocks of Facebook, Amazon, Netflix and Google, now Alphabet, and other big-name tech plays.

That 16 percent gain is reason enough for a drop in the Nasdaq, Cramer argued, especially in the month of September, which tends to bring bouts of selling.

Moreover, the S&P 500 and Dow Jones Industrial Average's performance — up 8 percent and 5 percent for the year, respectively — highlights why rotations happen in the first place, the "Mad Money" host said.

"No wonder the same people ringing the register on the high-flying Nasdaq are now going bargain-hunting in the Dow," he said on Wednesday.

Key non-tech stock groups, particularly the industrials, also tend to benefit in moments like these, Cramer said. With tech stocks falling and no trade-related Trump tweets in sight, investors are beginning to see opportunity in big cyclical stocks like 3M.

In fact, the stock of 3M, which has undergone China- and auto-market-related pressures for much of 2018 before finally bouncing thanks to its latest quarter, is perfect for an interesting rotation-day exercise, Cramer said.

He looked at the struggling stock of Facebook, down more than 2 percent on Wednesday amid Senate testimonies by COO Sheryl Sandberg. After the decline, the stock was trading at roughly 23 times next year's earnings estimates.

Using Facebook's price-to-earnings multiple to compare apples to apples, Cramer then noted where the resurgent 3M trades: at about 20 times next year's earnings.

"Facebook has a much, much faster growth rate than 3M, so you'd think it would merit a much higher price-to-earnings multiple," Cramer said.

"But ... not many investors have faith in Facebook's ability to meet those estimates," he continued. "When I listened to COO Sheryl Sandberg testify about the need to get more rigorous about policing bad behavior, all I could think was, 'Holy cow, that's gonna be expensive.' So, what's happening at FB? Costs are going up; revenues [are] slowing down. That's a recipe for earnings cuts, not increases."

On the other hand, 3M's most recent quarter put the Scotch tape maker back into "acceleration mode," making the stock a more attractive buy than the politically embroiled Facebook, Cramer said.

So as investors wait for the disparaged tech sector to settle, the "Mad Money" host reiterated a key piece of his investing advice: Diversification is key.

"Here's the bottom line: If you owned all tech, you probably felt like today was, indeed, the end of the world. That's why I'm always telling you to own a diversified portfolio," he said. "As long as you owned some industrials, today was just fine. Rotations are inevitable. Stocks don't go up in straight lines. In short: keep calm; carry on."

WATCH: How Cramer interprets market rotations

Disclosure: Cramer's charitable trust owns shares of Facebook, Amazon, Alphabet and 3M.

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