Measuring Sector Cyclicality: A Factor-Based Approach

Abstract

Equity sectors are often ascribed static economic classifications that fail to consider their dynamic and time-varying fundamental characteristics across business cycles. Leveraging research findings on factor cyclicality, the authors propose a simple and practical methodology to categorize sectors as cyclical or defensive by estimating their sensitivity to a cyclical multifactor portfolio. Their results reveal that although some sectors have exhibited persistent cyclical or defensive features, most sectors have experienced noteworthy changes over time. Using a predictive business cycle regime framework, they document the effectiveness of this dynamic factor-based sector classification approach and provide examples of sector rotation strategies that have historically generated attractive excess returns, outperforming static alternatives. Their results are consistent with a factor investing paradigm, recognizing that factors are important drivers of portfolio risk and performance, and traditional asset classes can be seen as implementation vehicles of intended factor and macro exposures.