Economic performance tends to fluctuate over time. When an economy is growing, we say it is expanding. When it is declining, we say that an economy is contracting. An extended period of economic decline is called a recession.
Due to the nature of market forces, economies tend to follow this pattern of behaviour, expanding and contracting, over long periods of time. We call this pattern of economic activity a business cycle.
There are four phases of a typical business cycle:
The early cycle phase marks the transition from previous recession to growth. In this phase we are seeing a recovery or economic expansion. Often credit is easier to obtain as people become more and more optimistic about the economy. Business inventories are low and sales are improving.
This is generally the longest phase of the business cycle. The economy is gathering steam, and credit growth is strong. Businesses that may have been struggling before are regaining profitability.
The economy is starting to overheat. There may be excess supply. Pockets of illiquidity may start to build up, and company profits are starting to take a hit. With pressure on company earnings and lending starting to taper off, growth may start to stall at this point.
This phase is marked by a genuine contraction in economic activity. Profits decline and lending comes to a standstill. Government policy may become very accommodative so as help stoke a quick recovery.
So how does knowing the different parts of a business cycle help you? As it turns out, savvy investors can use the business cycle to position their investments accordingly.
For instance, stocks tend to perform strongest during the early phase of a business cycle while defensive assets like bonds do the opposite, and perform best during recessions. A smart investor knows to adjust his portfolio allocation between stocks and bonds depending on which phase of the business cycle he is in.
So does that mean one should invest in stocks in the early phase of a business cycle and then not at all afterwards?
Not all securities move together at the same time. Within the overall market there are subsections of stocks that tend to perform better than others, that take leadership so to speak, and different sections take leadership as the business cycle progresses.
Before we continue we need to talk about what these subsections of the overall market are.
The 10 Equity Sectors
Equity sectors are subsections of the market as a whole. Companies are grouped together in different sectors based on their similarities. For example, Apple Computer and Microsoft are both tech giants, part of the overall U.S. stock market, and are grouped together in the “Information Technology” equity sector.
There are 10 such sectors. They are, in alphabetical order:
General Motors, Home Depot, Comcast; these are businesses that sell goods that aren’t absolute necessities. This sector includes automobiles, media, retailing and others.
Proctor & Gamble, Cocoa Cola, British-American Tobacco; companies in this sector sell goods that people are always going to have a need for; they provide the essentials, or “staples” such as food, beverages, tobacco and other household items.
Chevron, Exxon Mobil, Conoco Phillips; these are companies that are in the business of producing or supplying energy.
Bank of America, Berkshire Hathaway, Wells Fargo; these are all companies that provide financial services. This equity sector includes banks, investment funds, and insurance and real estate companies.
Aetna, Cigna, United Health Group; this equity sector includes the providers of health care equipment and services.
General Electric, Boeing, Caterpillar; these companies produce goods used in construction and manufacturing. This sector includes companies that are involved in aerospace, defense, industrial machinery, and construction.
Intel, Google, Facebook; this sector includes businesses that manufacture electronics, create software or provide services related to the area of information technology. You may find companies involved in the production of semiconductors, personal computers, or even televisions.
Monsanto, Dow Chemical, Ecolab; in this equity sector you will find companies involved in the discovery, refinement, and production of raw materials as well as industrial chemicals.
Verizon, AT&T, T-Mobile; the companies in this sector specialize in telecommunication services. They provide you with your telephone and internet services.
American Electric, PG&E Corp, Duke Energy; this equity sector includes companies that provide consumers with utilities such as gas, electricity and water.
What Does It All Mean?
If we look at history we see that the relative performance, relative to the overall market, of equity market sectors tends to rotate as the economy moves from one phase of the business cycle to the next.
What that means is that certain sectors of the economy perform better than others during specific phases of the business cycle.
Sectors that generally do well in this cycle are ones that are interest-rate sensitive. During the early phase, government monetary policy is set so as to help the economy fire on all cylinders. Interest rates may be set at extremely low levels so as to encourage lending by banks. As a result banks that are able to borrow from the government at almost zero cost during this phase tend to do well.
When an economy has just started pulling itself out of recession, Consumer Discretionary and Financials tend to do best, benefitting from a backdrop of low interest rates.
There are certain industries that see a healthy demand for their products and services only after people are confident that the economy is healthy. In the mid cycle phase we see leadership of stock performance move away from interest-rate sensitive sectors.
During this phase, the economy is healthy, employment is up and industrial activity starts to pick up.
As the economy starts to gain some steam, leadership typically moves to Information Technology as well as certain industries WITHIN the Industrials equity sector.
During the late cycle phase the Energy and Materials sectors tend to do well as demand for raw materials remains strong.
As investors start to suspect that the economy is slowing down, money starts to flow into typically defensive sectors such as Consumer staples, Health care and Utilities.
This is usually the shortest phase; economic growth has stalled and the economy is contracting. Defensive sectors do best here, such as Utilities, Telecoms, Health Care and Consumer Staples. Companies in these sectors are producing goods that people are less likely to cut back on in lean times.
The Bottom Line
The business cycle approach to investing allows one to take advantage of relative sector strength. As an economy transitions from one phase to the next, a strategy of rotating into sectors that perform best in that phase allows investors to maximize their portfolio returns – this is called sector rotation.
Additionally because phases and the business cycle tend to take place over an intermediate timeline, say months and years, sector rotation becomes a very practical approach for investors who are not watching the markets every day.
There are even exchange-traded funds – ETFs –that replicate the different equity sectors and are open to any class of investor, making this strategy an appealing one. For example, BlackRock – an American investment management corporation – manages a family of ETFs known as the U.S. iShares. Each iShares fund tracks a different stock market index or equity sector that makes it very simple to invest in a specific sector; i.e. U.S. Consumer Staples.
The drawback to sector rotation is that when you jump from one ETF to another you will incur commission costs associated with the active management of your portfolio. However, if done correctly the returns should more than make up for it!
Finally, one has to study the intricacies of sector rotation to be truly successful at it. The phases described in this article are not guaranteed. The phases do not always progress in order. There have been occasions where the economy skips a phase or lives in one phase for an extended period of time. Additionally being able to understand when an economy is switching from phase to phase in an art in itself.
Take the time to understand this, though, and you will be a better investor for it!