Sector Analysis2025-11-10
Sector Rotation ETF Strategy by Economic Cycle
Since each sector's performance varies with the economic cycle, a well-considered sector ETF rotation strategy is essential. Understanding the characteristics of sector ETFs such as XLK, XLF, XLE, and XLV, and establishing an optimal allocation for each phase of the economic cycle, is key to success.
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As of November 2025, the U.S. economy is in the early stages of a rate-cutting cycle and is assessed to be in late expansion or early slowdown. Since sector performance varies significantly with the economic cycle, an appropriate sector rotation strategy is necessary. The technology sector (XLK) tends to outperform during rate cuts, the financial sector (XLF) benefits from rising rates, the energy sector (XLE) provides an inflation hedge, and the healthcare sector (XLV) offers defensive characteristics. Use an asset allocation calculator to determine the optimal sector weighting for each economic phase, and a rebalancing calculator to identify the right time for quarterly adjustments.
The Four Stages of the Economic Cycle and Sector Performance
The economic cycle is broadly divided into four stages. During the Recovery phase (trough to early expansion), GDP growth shifts from negative to positive, unemployment falls, and consumer sentiment improves. Interest rates remain low as the Fed maintains an accommodative policy. Outperforming sectors in this phase include Financials (XLF), as expectations of economic recovery drive loan demand and net interest margin improvement; Technology (XLK), as growth stock valuations recover along with investor sentiment; and Consumer Discretionary (XLY), as consumer spending picks up and demand for retail and travel rebounds. During the Expansion phase (mid to late cycle), GDP growth exceeds potential, employment is strong, and unemployment is at its lowest. Inflationary pressures build and the Fed gradually raises rates. Leading sectors are Technology (XLK), with high earnings growth and active innovation investment; Industrials (XLI), benefiting from rising capital expenditure and infrastructure spending; and Energy (XLE), as crude oil demand increases and the sector provides an inflation hedge. During the Slowdown phase (peak to early recession), GDP growth decelerates and corporate earnings forecasts are revised downward. Unemployment begins to rise and the Fed ends tightening or pivots to easing. Outperforming sectors are Healthcare (XLV), with strong defensive characteristics and stable demand for essential medical services; Consumer Staples (XLP), which maintains demand despite the slowdown and offers stable dividends; and Utilities (XLU), benefiting from increased safe-haven demand and providing attractive dividend yields. During the Recession phase (sustained contraction), GDP growth turns negative, unemployment spikes, and corporate defaults rise. The Fed aggressively cuts rates and implements quantitative easing. Leading assets are Bonds (AGG, TLT), which generate significant capital gains as rates fall amid surging safe-haven demand; Healthcare (XLV) and Consumer Staples (XLP), which hold up relatively well as defensive sectors; and Gold (GLD), driven by increased risk-aversion demand.
Analysis of Key Sector ETF Characteristics
XLK (Technology Select Sector SPDR Fund) represents the technology sector, comprising 68 tech stocks within the S&P 500. Its top holdings include Microsoft, Apple, Nvidia, and Broadcom, with a low expense ratio of 0.09%. It has delivered the highest 10-year annualized return of approximately +20%, while carrying a low dividend yield of 0.6% and relatively high annual volatility of 25%. It outperforms during economic recoveries, expansions, and rate-cutting cycles, and underperforms when rates spike or during recessions. XLF (Financial Select Sector SPDR Fund) represents the financial sector, comprising 72 banks, insurers, and brokerages. Top holdings include Berkshire Hathaway, JPMorgan, Visa, and Mastercard, with an expense ratio of 0.09%. The 10-year annualized return is approximately +12%, dividend yield is 1.6%, and annual volatility is 20%. It outperforms during rising rate environments and economic recoveries, while underperforming when rates fall or during credit crises. XLE (Energy Select Sector SPDR Fund) represents the energy sector, comprising 23 oil and gas companies. Top holdings include Exxon Mobil, Chevron, and ConocoPhillips, with an expense ratio of 0.09%. The 10-year annualized return is approximately +5%, dividend yield is a high 3.5%, and annual volatility is a very high 30%. It outperforms during inflationary environments and oil price rallies, and underperforms during recessions and oil price declines. XLV (Health Care Select Sector SPDR Fund) represents the healthcare sector, comprising 64 pharmaceutical, biotech, and medical device companies. Top holdings include UnitedHealth, Johnson & Johnson, Eli Lilly, and AbbVie, with an expense ratio of 0.09%. The 10-year annualized return is approximately +13%, dividend yield is 1.4%, and annual volatility is a low 16%. It outperforms during economic slowdowns and defensive market environments, while exhibiting relative underperformance in the later stages of a bull market.
Current Economic Phase Diagnosis and Sector Strategy
As of November 2025, the economic phase is assessed to be late expansion or early slowdown. Key indicators show GDP growth at an annualized rate of 2.1%, near potential growth with signs of deceleration; unemployment at 3.8%, low but showing early signs of an upward turn; inflation with CPI at 2.4% and trending lower; and interest rates at 4.5%, in the early stages of a rate-cutting cycle. The characteristics of this phase are that the economy has passed its peak and is in the early stages of slowing, the Fed has pivoted to an accommodative policy, corporate earnings growth is decelerating, and investors are rotating toward defensive assets. The recommended sector strategy calls for overweighting Healthcare (XLV) at 25%, given its strong defensive characteristics and stability during economic slowdowns; Consumer Staples (XLP) at 15%, a defensive sector with stable dividends; and Technology (XLK) at 20%, which benefits from rate cuts, though weighting should be calibrated to account for valuation concerns. Underweighting is recommended for Financials (XLF) at 10%, due to concerns about net interest margin compression as rates fall; Energy (XLE) at 5%, as crude oil demand is expected to decline during a slowdown; and Consumer Discretionary (XLY) at 10%, given the potential for consumer spending to decelerate. As a defensive complement, Bonds (AGG, TLT) at 15% provide portfolio stability and benefit from falling rates. The rebalancing strategy involves reviewing economic indicators on a quarterly basis and adjusting sector weights following releases of GDP, employment, and inflation data; using a rebalancing calculator to make adjustments when actual allocations deviate by ±5% from target; and using an asset allocation calculator to assess overall portfolio risk.
How to Execute Sector Rotation
Here is a step-by-step approach to executing sector rotation. Step 1 — Assess the Economic Phase: analyze key indicators such as GDP, employment, inflation, and interest rates; refer to the Fed's FOMC statements and economic projections; and monitor leading indicators such as PMI and consumer confidence indices. Step 2 — Set Target Sector Weightings: identify sectors that tend to outperform in the current economic phase; use an asset allocation calculator to determine appropriate risk levels; and balance defensive and growth-oriented sector allocations. Step 3 — Review the Current Portfolio: check the current weighting of each sector ETF; measure how far the portfolio has drifted from target weights due to performance changes; and use a rebalancing calculator to identify sectors that need adjustment. Step 4 — Execute the Rebalancing: partially sell sectors that are overweight; buy underweight sectors to bring the portfolio back to target weights; and consider trading costs when deciding whether to adjust in one transaction or through gradual purchases. Step 5 — Monitor and Re-evaluate: review the strategy following quarterly economic data releases; respond promptly if economic conditions deviate from expectations; and combine four scheduled rebalancings per year with ongoing monitoring. As a practical example, the Q1 2025 portfolio was XLK 30%, XLF 20%, XLE 10%, XLV 15%, XLP 10%, AGG 15%. After detecting signs of economic slowdown in Q2, the portfolio was adjusted to: XLK 20% (reduced by 10pp), XLF 10% (reduced by 10pp), XLE 5% (reduced by 5pp), XLV 25% (increased by 10pp), XLP 15% (increased by 5pp), and AGG 25% (increased by 10pp). The effect of the adjustment was that defensive sectors outperformed during the slowdown, limiting portfolio losses. Gains of +5% in XLV and +3% in XLP helped offset declines of -8% in XLK and -10% in XLF.
Key Considerations When Investing in Sector ETFs
There are several important considerations when investing in sector ETFs. Concentration risk: sector ETFs are concentrated in a specific industry, so a downturn in that sector can lead to significant losses. The energy sector (XLE) is heavily influenced by oil price volatility — it fell -40% during the 2020 oil price crash. Due to limited diversification, investors should spread capital across multiple sectors or blend sector ETFs with a broad-market ETF like SPY. Timing risk: it is difficult to time sector rotations to coincide precisely with economic phase transitions. Rotating too early results in opportunity cost, while rotating too late means the move may already be priced in. Economic phase assessments can also be wrong, particularly when key indicators are sending mixed signals. Mitigation strategies include gradual adjustments rather than large-scale transitions all at once, a conservative approach that favors defensive sectors when uncertain, and using multiple indicators rather than relying on a single data point. Trading costs and taxes: frequent sector rotations accumulate transaction costs (commissions and spreads), and positions held for less than one year may be subject to higher short-term capital gains tax rates. To minimize costs, limit rebalancing frequency to quarterly reviews; use a rebalancing calculator to assess whether the benefit of an adjustment justifies the cost before acting; and consider using retirement accounts to defer capital gains taxes. Recommended strategy: construct the core portfolio with broad-market ETFs such as SPY or VTI, accounting for 60–70% of the portfolio; limit sector ETFs to a tactical allocation of 20–30%, adjusted according to the economic cycle; and maintain a 10–20% allocation to bond ETFs such as AGG or TLT as a defensive buffer to reduce portfolio volatility.
Conclusion
Sector rotation based on the economic cycle is a strategy that can enhance portfolio returns. In the current early-slowdown environment, it is advisable to increase exposure to defensive sectors such as Healthcare (XLV) and Consumer Staples (XLP) while reducing weightings in Technology (XLK) and Financials (XLF). Use an asset allocation calculator to determine the optimal sector weightings for each economic phase, and a rebalancing calculator to guide quarterly adjustment decisions.
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