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“EXCELLENCE THROUGH KNOWLEDGE” P A G E 37 Sector Rotation and Interest Rate Policy This paper investigates the efficiency of equity allocation strategy based on changes in the U.S. prime bank rate. A sector rotation strategy based on changes in interest rates is one of the ways investors can maximize their returns. The study used the U.S. monthly bank prime loan rate from January 31, 1949 to December 31, 2012 as the indicator variable for interest rate changes, and changes in the rate were labelled as either expansive or restrictive policy shifts. The study evaluates the monthly returns equally weighted (including distributions) of U.S. equity stocks listed in the CRSP data base. Betas were obtained by regressing the monthly equally weighted returns against the monthly Dow Jones industrial index. The results show that a sector rotation strategy based on changes in monetary policy particularly interest rate adjustments can significantly improve the performance of an investor’s portfolio. The underlying thinking in sector rotation strategy is that you invest in sectors that are generally expected to perform well given the existing state of the economy, given that sectors perform differently when the economy is growing as against when it is not. This was the general message advanced by Stovall (1996). Stovall (1996) saw the economic cycle as a four phase phenomenon namely: full recession, early recovery, late recovery, and early recession. It also involved indicating which stocks performed well at each stage of the cycle. It is the view that cyclical stocks should be acquired at the beginning of a recession as these are stocks that normally perform well when the economy is in a growth phase (expanding) and perform poorly when the economy is contracting. The basic implementation of a sector rotation strategy requires that you allocate your investment by identifying the stages of the economic cycleand thenselling those sectors that areexpected toperformpoorly, and then acquiring sectors that are expected to do well. Therefore, the idea that different sectors within the economy benefit differently from the phases of the economic cycle, and thus the understanding that the prices of some sector indices do move independently of others, is not new. The idea of systematic sector rotation is based on the general principle that sectors within the economy do not follow the same pattern over time, but move differently one from another (Stovall 1996). It is argued that there are two main reasons that seem to underpin this behavior. Advocates argue that the first is the presence of fundamentals. These are sectors that benefit relative to Phillip C. James 1 , Il-woon Kim 2 , John J. Cheh 2 1 College of Business & Management, University of Technology, Jamaica 2 The University of Akron, USA Phillip C. James