Before mutual funds came to dominate the market in the late 1980s, sector rotation was not widely followed as a strategy. That’s because--aside from aggressive traders--no individual in their right mind would dump a perfectly good stock just because something else was expected to do better over the next few weeks.

The rise of funds and other big institutions, however, has dramatically changed market dynamics, at least near-term ones. While individuals are content to build wealth over time through growing companies, funds are constantly under pressure to put up strong performance numbers.

Managers with absolutely superior long-term records may get a pass for a bad quarter or two. But a bad year--which may be just lagging the performance of the S&P 500--will invariably provoke criticism and speculation that he or she has “lost his touch.” And a couple of bad years can bring down even the biggest name. Lesser lights, meanwhile, will flame out much sooner.

As a result, the guys who manage big time mutual funds and institutional money aren’t going to wait around for a long-term situation to pan out. They simply can’t afford to ride down a position that’s temporarily undervalued and underappreciated.

Neither can they afford to stick with an underperforming sector when another is off to the races.

The old adage that, in the long haul, the stock market is a weighing machine still holds. Eventually, a strong, growing company will get the superior valuation it deserves in the market place. Conversely, a weak company will ultimately get its comeuppance, no matter how high it seems to fly.

The corollary that the stock market is a popularity contest in the short haul, however, is truer than ever. Mutual funds and big institutions with short-term performance goals simply can’t afford to ignore popular stocks or sectors, or to stick with unpopular alternatives.

The result is sector rotation on a scale never before witnessed in US markets. Popular stocks are run to unimaginable heights by what’s literally panic buying by managers who are terrified to be left out of their runs. Similarly, selling of unpopular stocks and sectors now frequently runs well past what fundamentals and other real world developments justify, since no one wants to be left holding the bag.

Since late 2002, for example, the US economy has generally run on an even keel. Interest rates and inflation have been under control and growth has continued to chug along. Any time things have run too fast, interest rates have adjusted upward and the trend has been brought under control. And when things have slowed, rates have come down and revived growth.

In general, the stock market has been in an uptrend over that time.

But we’ve seen some mind-bending swings in individual stocks and sectors. For example, summer 2003, spring 2004, spring 2005 and spring 2006 all brought monster selloffs in dividend-paying stocks.

Those who followed the trend sold low and were forced to buy back high later in the year.

Sector rotation during the past few weeks has been equally violent.

The chief victims have been in the energy sector, where stocks across the board have crashed and burned, from Big Oils to providers of energy services and Canadian oil and gas producer trusts. The chief beneficiaries have been the big industrial blue chips in the Dow Jones Industrial Average and a wide range of technology stocks.

The Dow itself hit a new all-time high this week and the Nasdaq has scored one of its bigger gains in a while.

SHOULD WE MOVE?

Is this rotation worth playing?

If you’re a big institution or mutual fund, the answer is you probably can’t afford not to. At this point, we still haven’t seen a clear bottom for either oil or natural gas prices. OPEC has stated it will cut output to defend an oil price of $50 to $55 a barrel.

But inventories of both oil and gas are still at high levels and a mild winter--as some forecasters are predicting due to an El Niño weather system--would only keep them there.

Most important, energy stocks are still weak. We had a couple of days this week when prices seemed to stabilize and move a bit higher. But today’s action is once again to the downside.

Interest rates, meanwhile, continue to be volatile. After briefly breaking toward 4.5 percent, the benchmark 10-year Treasury note yield has rebounded sharply and is again approaching 4.7 percent, despite the fact that job creation for September of 51,000 was well below consensus projections of around 120,000.

The employment report is yet another sign that this economy continues to chug along, not too fast and not too slow. But today’s action seems to indicate a consensus view that a recession is less likely, and that the Federal Reserve may have to start raising rates again to control inflation, despite estimates that growth slowed to just 1 percent in the third quarter.

The threat of rising interest rates hasn’t done much to hurt prices of more conventional yield paying stocks like utilities, which are still sitting pretty close to all-time highs. We are seeing some selling, however, in more exotic yield payers, such as income deposit securities.

For individual investors, however, there’s little reason to do anything at the moment, other than continue to monitor the underlying businesses of our holdings. We can also look to add quality stocks and bonds when prices reach irresistible levels, which should unfold over the next several weeks.

The not-too-hot, not-too-cold economic data don’t justify unloading good yield-paying investments, particularly if their businesses are growing at a reliable and steady clip. That’s the hallmark of our recommendations in Utility Forecaster, Canadian Edge and Personal Finance.

As far as energy goes, its major purpose in an income portfolio is always to hedge against environments when inflation is on the move, interest rates are headed higher and the majority of income stocks are weak. During the past several years, rising energy prices have kept a lid on interest rates by keeping economic growth from getting out of control. As a result, we’ve seen income investments and their hedge--energy stocks--rise at the same time.

That’s never been a normal state of affairs, and it now seems the relationship is returning to its historical pattern. Nonetheless, energy remains in a long-term bull market and will be until we see the same factors that ended the 1970s run: Conservation, greater use of alternatives to oil and gas, a major discovery of conventional reserves like the North Sea of that era and probably a major recession.

Again, none of these factors are in evidence today. That means sooner or later, the current weather-related surplus inventories of oil, gas and coal are going to be soaked up. Meanwhile, the world remains extraordinarily exposed to an interruption in supply from almost any source, since the margin between capacity levels and current levels of production remains extraordinarily narrow.

Energy prices and energy stocks may come down even more in the near term. For one thing, I’m not wholly convinced the speculative long positions of institutions, traders and hedge funds have been wholly unwound in either oil or gas.

The important thing is that today’s pain is only discouraging conservation, use of alternatives and exploration for new conventional reserves, even as it revs up growth and makes a global recession less likely. The Federal Reserve’s holding pattern on interest rates is a good sign it isn’t going to do anything to rock the boat, but rather will wait for a slowing economy and cooler oil prices to bring down a core inflation rate that’s started to climb and is above its target.

That means lower prices now ensure higher prices down the road.

Energy stocks have already taken a severe beating. But as they now appear to be pricing in oil of $40 or lower in many cases, downside is limited. And while it’s still too early to look at weaker picks in the sector, it’s far too late to dump them wholesale, except for the real weaklings. These may not make it out of this in one piece.

And in any case, it’s far better to unload them even at these prices, so you can have your bets concentrated in the higher-quality fare that will lead the rebound.

BOTTOM LINE

Income investors need to ignore the sector rotation and stick with the high-quality companies they’ve accumulated.

Being an income investor means sticking around long enough to collect dividends and interest payments, and you won’t do that if you’re always trying to rotate sectors. Turnover is a major reason why most so-called income funds never pay decent dividends. They’re simply too busy jockeying around to boost quarterly returns and don’t stay long enough to get dividends.

Another drawback of income investing sector rotation is it’s extremely inefficient when it comes to taxes. For one thing, you’re socked with capital gains taxes at the end of the year, which are impossible to forecast. For another, you won’t hold anything long enough to get the preferential 15 percent tax rate on qualified dividends.

Even companies with the strongest businesses have their ups and downs. And those gyrations can be wildly exaggerated by rampant sector rotation among the institutions and funds that dominate the current market. Those who use loss control rules--for example, selling anything that drops 20 percent below their buy price--are extremely vulnerable to getting whipsawed out of strong positions for no good reason.

Unless the underlying business fundamentals of the companies you own are weakening, the best course by far is simply riding out the volatility and living with shrunken profits or sitting with red ink for a while until the inevitable recovery. If you’ve chosen well, you’ll be rewarded for the wait with a solid stream of dividends.

You can smooth out the volatility of your entire portfolio simply by diversifying among income-producing investments in a multitude of sectors. As I said above, energy is generally a pretty good hedge against trouble in most income investments. Holding a wide mix of sectors also helps balance things out, as one’s outperformance can offset another’s underperformance.

The best example I can give of this occurred in the early years of this decade. While Wall Street was going through a crushing bear market, the utility sector suffered a thrashing of generational proportions, with the Dow Jones Utility Index falling 59 percent top to bottom.

Through that time, I held several utilities in the Personal Finance

Utilities, of course, have suffered declines of such magnitude only three times: 2001-02, 1972-74 and during the Great Depression. And vastly improved regulatory relations, rapid deleveraging, systematic reduction of operating risk and soaking up of the power supply glut make a repeat crash virtually impossible for some time to come.

Also, a good part of the damage I suffered with utility recommendations was self-inflicted. Had I followed a strict discipline of selling companies with weakening fundamentals, I would have avoided much of the damage. The point is that diversification literally saved the bacon from my worst instincts. And it will do so again, when another sector unexpectedly hits hard times.

Strong companies will gain ground over time as they become more valuable and meanwhile the balance will keep your overall portfolio value steady.

BONDS: It’s still a good time to buy bonds of financially recovering utilities, as declining credit risk will boost prices and offset interest rate risks. I prefer bonds with intermediate-term maturities (five years or so) and those that trade at premiums to par value, since many investors shun them. Closed-end bond funds with good track records are attractive, provided they trade at or near discounts to net asset value. The open-end funds in the Personal Finance Income Portfolio are great choices for the most conservative, including VANGUARD GNMA (VFIIX).

CANADIAN BUSINESS INCOME TRUSTS: This much-overlooked sector is loaded with strong businesses that are dishing out monthly cash yields ranging from 8 to 12 percent and growing them at double-digit rates.

CANADIAN OIL AND GAS ROYALTY TRUSTS: This sector has been bashed and should be near a bottom. But there are numerous smaller trusts that could still face dividend cuts and some are at risk to vanishing altogether. Stick to the strongest, like ARC ENERGY (TSX: AET.UN,

ENERGY UTILITIES: Prices are still near all-time highs for most top-quality utilities. My advice is to keep holding onto positions, but to wait to pick up shares until prices move below my buy targets.

ENERGY LIMITED PARTNERSHIPS: Returns from these lately have come almost exclusively from dividends, as prices have stalled. These make their money from throughput of energy through their pipelines and other assets, rather than from energy prices. As a result, they remain among the best income plays on the market and several tracked in UF are bargains.

ENERGY PRODUCERS: Easy does it with this group. You’re still best off holding high quality companies, i.e. those that can hold dividends and maintain business expansion even if oil drops well below $50 a barrel. But as I stated above, I don’t think we’ve touched bottom yet. Some of this group rate buys, particularly the Big Oils, utility/producers and the very strongest Canadian trusts.

But I suspect we’ll still see lower prices and a better opportunity in coming weeks. Continue to avoid US trusts, which represent wasting assets and are still at high levels.

FINANCIALS: My favorites here remain the regional banks, despite their recent sharp appreciation. The best of these will grow and make money in any interest rate environment, and the South is still the best region.

PREFERRED STOCKS: These are the red-headed stepchildren of the market and consequently offer superior yields to most bonds and common stocks relative to their risk. My favorites are issues of financially recovering utilities. I also like preferreds that are convertible into common stock of strong companies like NORTHROP GRUMMAN (NYSE: NOC)

REITs: This group is more expensive than ever and would be vulnerable if the US economy really slowed down. Exceptions are apartment REITs, which are only beginning to come out of their recent depression. There are also takeover plays in Canada.

TELECOMS: This has been among the stronger sectors over the past few months, as it’s become clear the shrinking number of players has left the survivors stronger than ever. The dividend-paying telecoms remain the sector’s best buys.

Roger Conrad is Editor of UTILITY & INCOME