Smart Money Moves

Edwin Kennedy is no buy-and-hold investor. HE’S always scouting for opportunities to boost the upside potential of his $150,000 stock and mutual fund portfolio. Recently, the Valley Stream, New York, resident shopped for stock in, of all places, the housing sector. Headlines about overflowing supply and plummeting prices drove many investors away from the industry, but Kennedy, who is married and the father of four, wasn’t fazed. “Whatever happens, people are still going to need homes,” says the 42-year-old New York state court police officer.

It’s true that home builders had a rough 2007: The S&P Homebuilding Index dropped 47.6% for the year. But a look at more recent figures suggests that Kennedy may be on to something. Through mid-March of this year, the index was up 2.5% while the S&P 500 was down 12%. Yet, in the end, Kennedy opted not to buy because of the volatility in the housing market. “The housing sector hasn’t bottomed out yet,” he says.

Kennedy was informally using sector rotation, an approach many professional investors employ to gain an edge. By anticipating the ups and downs of sectors such as energy, housing, and retail, they shift capital every few months out of stocks whose momentum is expiring and into other stocks whose run-they hope-is imminent.

There are multiple approaches to sector rotation. Some investors focus on the predictable boom-and-bust cycles of the economy. At various stages, different sectors seem to regularly thrive. For instance, when the economy is expected to slow down, it’s time to consider moving into relative safe havens such as healthcare and consumer staples, which are less exposed to downturns in consumer spending. Conversely, as a weak economy seems poised to strengthen, investors may want to look into sectors that would benefit from an uptick in corporate spending and manufacturing, such as chemical companies.

Such investors aim to buy stocks in the right industries, ahead of turns in the business cycle, and then watch them appreciate. Gains are maximized, of course, if investors can buy the stocks just before their sectors come back into favor-when the stocks are still bargains. Others base their decisions to buy or sell on isolated factors such as the earnings growth momentum of the companies in a given sector.

These varied approaches aim to beat a buy-and-hold strategy-which often loses money in a bear market. After all, a few strong sectors can be found even in a flagging market. Wall Street professionals have used sector rotation for decades, but with the proliferation of inexpensive online research and brokerage accounts, it’s possible for do-it-yourselfers to follow suit; however, it demands that investors be particularly proactive in monitoring their investments.

Picking individual stocks is the most time-consuming approach to sector rotation. Do-it-yourself investors must analyze business cycles and then take the time to research numerous companies in order to maintain diversified portfolios of stocks in at least half a dozen industries, says Sam Subramanian, chief investment officer of Houston-based AlphaProfit Investments L.L.C., and publisher of AlphaProfit Sector Investors’