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Sector Investing and Business Cycle Phases for Market-Beating Returns

Use this business cycle graph to plan your sector investing strategy around the natural phases in the economic cycle

Investors have a horrible track record of timing the market, trying to buy low and sell high. The range of short-term factors that play on investor sentiment makes it nearly impossible to judge exactly where stocks are going over a year or less.

But that doesn’t mean you can’t earn higher returns and avoid losses by understanding the business cycle better.

There are longer-term factors that can help you protect your investments and boost your investment return.

As an ownership on future earnings, stocks are intuitively linked to the economy and the business cycle. Business cycle phases are driven by large-scale and evolving factors like interest rates, employment and economic stimulus.

The fact that these factors are more stable and predictable makes sector investing around the business cycle phases the most reliable strategy you can add to your long-term plan.

In this post, we’ll talk about:

  • What the business cycle is and how to tell when changes will happen
  • Which assets do best in each phase of the business cycle
  • How stocks and stock sectors do during each phase of the cycle
  • Historical data and a proven strategy for investing in each phase of the business cycle

business cycle phases and sector investingStart by understanding the business cycle and where on the business cycle graph we are today before rebalancing your sector investments for protection and higher returns.

What is the Business Cycle?

As much as the government would like to think it can manage the economy, the business cycle is prone to fluctuations from euphoria to disappointment and finally rebirth. In fact, much of the changes in the business cycle can be tied directly to the government’s and the business sector’s attempt to manipulate the economy.

When the economy is stumbling and businesses are not hiring, the government tries to jumpstart growth by lowering interest rates and increasing spending on public projects. The increase in spending and low borrowing rates gives businesses a reason to hire and invest in their own growth.

This all acts to increase economic growth and can have a momentum effect where faster growth incentivizes more spending and investment.

Eventually, new workers become scarce and companies have to raise wages which cuts corporate profits. The government eases back on spending and raises rates to keep inflation from destroying the value of the dollar.

Higher borrowing costs, disappointing earnings and the potential for slower economic growth leads companies to scale back on their hiring and spending plans.

This leads to a slowdown and even drop in the economy…and the cycle begins again.

What are the Business Cycle Phases?

Business cycle phases tend to come in three- to seven-year cycles from boom to bust. These phases are known as early-cycle, mid-, late- and recession.

It’s important to understand a few things about the business cycle.

  • The phases don’t have distinct dates like, “Oh, we entered the late-stage last week.” The phases are a continuum with the economy slowly moving through them.
  • Business cycles vary with some moving very quickly through the stages and the length of each stage can vary. It all has to do with the flow of economic factors and any unexpected shocks to the system.
  • Business cycle phases can repeat or even move into an earlier phase on government efforts to reinvigorate the cycle.

Take a look at this business cycle graph for factors within each phase as well as an estimate of where different countries are in their cycle.

business cycle graph 2017

Business cycle phases and best stock sectors for each phase

The early-cycle or recovery phase in business comes as the government and central bank try to jumpstart the economy with increased spending and by lowering rates. Banks ease their lending standards and credit opens up again. Industrial production and manufacturing increases on large capital orders and eventually other business sectors start hiring.

The mid-cycle phase is usually the longest part of the cycle and sees continued economic growth though the rate of growth is a little slower than in the recovery. Business hiring and economic growth has been confirmed by now, giving banks more confidence to open lending completely. Government spending programs are starting to finish and the central bank will usually stop lowering interest rates.

Later in the mid-cycle, companies start to see earnings growth slow though it’s still positive. To keep earnings per share growing, management resorts to spending cash on share repurchases.

The late-cycle phase starts showing signs of an over-heating economy. This is where unemployment has dropped to the point where employers are having a difficult time hiring. Wages start to grow faster to draw new employees from other jobs. This combined with overall economic growth means that inflation starts to increase. The increase in wages also starts to limit corporate earnings growth and may disappoint investors.

It’s in this phase of the business cycle that the government starts to think about reducing its debt and may cut spending. The central bank will also start raising rates to keep inflation from getting out of control.

The headwinds from government and monetary restrictions, combined with downsizing corporations to support earnings, pushes the cycle into the recession phase. It only takes one quarter of disappointing earnings for companies to start seriously retrenching to protect their business from an expected recession. It’s often a self-fulfilling prophesy as the expectation of a turn in the business cycle causes businesses to take measures that ensure the change.

To counteract the recession, the government and monetary authorities once again plan stimulus programs and lower rates.

We’ll get into defining points and how to plan your sector investments around each phase in the business cycle later. There’s another key point to strategic investing you can get from the graph. Since countries manage their own economies, their business cycles won’t necessarily happen at the same time.

With large economies like the U.S., China and Japan driving global growth, business cycles tend to coincide because of coordinated economic stimulus but it’s not always the case. Planning new investments in international markets and taking a larger view of the markets can help boost returns even further.

Which Assets Do Best in Different Business Cycle Phases?

Specific business cycle phases affect different assets and stock sectors in different ways. This is the very core reason of portfolio diversification and why you need to spread your investments across asset classes and sectors. Diversification helps to smooth your returns through exposure to asset classes and investments that do better at different times of the business cycle.

Since stocks are an uncertain call on future earnings of the business, they fluctuate more than other assets along with the business cycle. Business earnings fall and the future becomes uncertain in a recession so the value of those potential earnings is worth less and stocks plunge.

Sectors of the economy react differently though and we’ll get into sector investing next. Sectors like utilities and consumer staples which have relatively stable sales hold up better while so-called cyclical sectors like technology and materials drop harder in the later stages of a business cycle slowdown.

Bonds are the traditional safety investment when the business cycle shifts into the late- or recession phase. Fixed income investments are contractual obligations that companies must pay before shareholders get anything. This means more investment certainty against the uncertain business environment and bond prices hold up.

There are fundamental reasons for fixed income performance through the business cycle as well. Since bond payments are fixed, inflation is the mortal enemy of the bond investor because it decreases the value of the payments. For the same reason, bond prices rise when interest rates decrease and prices fall when rates increase.

Just as in stocks, there are parts of the bond market that do relatively better or worse depending on business cycle factors. Prices for high-yield bond, debt of financially weak companies, tend to follow the business cycle up and down because the companies’ ability to make debt payments is more uncertain with the weakening business environment.

Peer lending investing is becoming an alternative between stocks and bonds with higher returns than traditional bonds and less risk than stocks.

  • The investments are loans to individuals, so they are still debt obligations to pay though payment is less certain than the debt of large corporations
  • Safer borrowers have strong credit history and stable finances, providing more certainty than higher-risk borrowers
  • Peer loan returns tracks the business cycle slightly more than bonds because individuals’ ability to pay tracks employment
  • Returns on peer loans range from 5% to 12% on a diversified portfolio

Check out this interview with a peer to peer investor and my own criteria for picking loans.

Real estate presents another alternative to stocks that can help smooth your returns across the business cycle. Real estate is a hard asset so its value tends to increase along with inflation though higher interest rates tend to limit appreciation because of the heavy-use of borrowing in real estate investment.

Within real estate, commercial properties like retail and office space tend to follow the business cycle more closely for obvious reasons. By comparison, residential and self-storage values are relatively immune to changes in the business environment.

Learn how to find and invest in real estate while avoiding the passive income myth in rental property.

Sector Investing Using the Business Cycle

Fidelity studied business cycle changes and stock sector returns from data back to 1962. While no sector of the economy always outperformed or underperformed in specific phases of the cycle, there were consistent trends. The data allowed for analysts to study returns over six full business cycles.

Returns for each sector where measured on three metrics.

  • Full-phase average performance shows the return of the sector during the business cycle phase after accounting for overall market performance, i.e. removing the average return on all stocks to just see how the sector performed.
  • Median monthly difference shows the sector returns after accounting for overall market performance but takes a monthly approach rather than across the entire business cycle phase. This is important because it shows return potential even if you don’t time the phases perfectly.
  • Cycle hit rate measures the percentage of times a sector outperformed during a specific sector so it gives an idea of the strength in the sector for business cycle investing.

Early- Business Cycle Sector Investing

Best stock sectors during the early business cycle phase

Best stock sectors during the early business cycle phase

Data showed that the stock market grew by an average 24% on an annualized basis during the early-phase of the business cycle and the phase tended to last approximately 15 months.

Interest-rate sensitive and sectors most closely-tied to the economy tend to do best in the early innings of an economic recovery. Financials tend to do well because of the quick pick-up in lending while investor enthusiasm in consumer discretionary and economically-sensitive sectors has the most to gain from a recovery.

The graph shows the most certainty in outperformance of consumer discretionary and industrials and the most certainty in underperformance in energy, utilities and telecom. Stocks of consumer discretionary companies tended to outperform the market by 12% while telecom stocks underperformed by about the same amount.

The poor performance in utilities and telecom is partly because of these sectors’ status as safety investments and the nature of their counter-cyclical revenues. Investors move to utilities and telecom when the economy falls apart so the opposite is true when businesses start growing again.

Mid- Business Cycle Phase Investing

Data showed that the stock market grew by an average 15% on an annualized basis during the mid-phase of the business cycle and the phase tended to last approximately four years.

Business cycle sector investing during mid-cycle phase

Business cycle sector investing during mid-cycle phase

Economically-sensitive sectors still tend to outperform during this phase but the results are less certain than other phases. Economic growth starts to slow a little from the early-stage recovery and the market is especially prone to shocks that can throw stocks for a loop. For this reason, sector leadership rotated frequently in the Fidelity study.

Energy, health care and telecom stocks all managed to outperform the market in about two-thirds of the business cycles though returns were only barely above the rest of the market. Materials, consumer staples and discretionary underperformed but only in one-in-three cycles.

Stocks in the technology sector had the highest average return during the mid-stage business phase but the hit rate was only 50%, meaning that the sector outperformed in half the cycles and underperformed in the other half. Some industries within the technology sector, most notably software and computers, do better because of increased business confidence and spending.

The most appropriate course for investors is probably to be more sector-neutral during the mid-cycle phase. Few sectors consistently outperform and returns are typically not far above the market anyway. Clues to the mid-cycle phase are not as obvious as other phases of the business cycle so it’s also less obvious when to adjust your investments.

Late- Business Cycle Stock Investing

Data showed that the stock market grew by an average 9% on an annualized basis during the late-phase of the business cycle and the phase tended to last approximately 18 months.

Best stocks for late business cycle period

Best stocks for late business cycle period and before recession

Economically-sensitive sectors still tend to outperform during this phase but the results are less certain than other phases. Economic growth starts to slow a little from the early-stage recovery and the market is especially prone to shocks that can throw stocks for a loop. For this reason, sector leadership rotated frequently in the Fidelity study.

With the late-stage of the business cycle, we again get greater certainty in sector investments and performance.

Stocks in the energy sector have outperformed in four-of-five phases while telecom stocks have underperformed half the time. Energy and stocks of materials companies do well because economic demand is still high and inflationary pressures support prices for hard assets like oil and commodities. Energy stocks tended to beat the market by 14% on average while materials companies tended to an 8% outperformance.

The consumer discretionary and technology sectors tended to underperform the market because of their sensitivity to the economy. Stock prices are high for companies in the sectors on strong performance in the earlier phases. As investors start worrying about an eventual recession, they abandon these sectors and prices fall.

Investing in Stocks During the Recession Phase of the Business Cycle

Investors panic and the stock market falls by an average 14% on an annualized basis during the recession-phase of the business cycle and the phase tended to last approximately 10 months.

Stock sector investing during a recession

Stock sector investing during a recession

The rush to defensive sectors like consumer staples, utilities and telecom offer some hope for positive return while economically-sensitive sectors are shunned.

Consumer staples outperformed in all six recessionary-phases studied over the time period from 1962 to 2012. Stocks in the utilities and telecom sectors outperformed in over 80% of the phases. Across the three sectors, returns during recessions ranged from 13% for utilities to about 8% for telecom stocks.

Stocks of technology and industrials companies did the worst on average, losing around 6% on average during a recession, but the underperformance wasn’t as certain with a hit rate of only around 18% over the period.

Reasons for the outperforming sectors is intuitive. People must buy food and other consumer staples whether the economy is growing or not. They also tend to pay their utility and cell phone bills during recessions. In contrast, technology companies and industrials are heavily dependent on business spending which drops on the economic decline.

Business Cycle Approach to Sector Investing

Sector investing around the business cycle isn’t about short-term market timing but can be used as a supplement along with your long-term investing strategy.

Stocks will outperform bonds and real estate as the economy grows so the portion of your portfolio in stocks increases relative to these other assets. That means you need to rebalance your portfolio every year or two to bring the risk in stocks closer to your target according to your investor policy statement (IPS).

While you are rebalancing the asset classes, you can also shift your stock investments to be ahead of changes in the business cycle. Use the table below along with the business cycle graphs above to plan your rebalancing strategy.

The recommendations in the table for each phase of the business cycle are the general market reaction to each sector so you may want to make changes in your portfolio before the cycle to be ahead of other investors. For example, stocks in the utilities sector tend to outperform in the late- and recession-phase of the business cycle as investors scramble for safety so you may want to buy into these companies on clues that the mid-phase is coming to an end.

Guide to Sector Investing during Business Cycles

Guide to Sector Investing during Business Cycles

As mentioned, you might want to consider a sector-neutral stance during the mid-phase since there is no clear winner among the sectors. Take advantage of more certainty, especially in the recession- and early-recovery phases to overweight your stock portfolio with the sectors that outperform.

Since business cycles tend to last between five and seven years on average, you might not need to rebalance your portfolio every year. If stocks have not zoomed higher and there are no clues to a shift in the business cycle, save money on fees by waiting six months or another year to rebalance.

When your allocation to stocks is more than 10% above or below your target allocation or when there are significant clues to a shift in the cycle, take the opportunity to make general changes in your portfolio. This might only happen once every couple of years but it can help you improve your return significantly and protect past gains.

Besides this general rebalancing, you’ll also want to revisit your investor policy statement every ten years or so to make sure your investments and target asset allocation follows your tolerance for risk and long-term goals closely.

Sector investing according to business cycle phases can be a great supplement to your long-term investing strategy, increasing returns and protection your money ahead of recessions. Rather than trying to time investor sentiment and short-term market moves, clues around changes in phases makes business cycle investing a rational way to rebalance your portfolio.

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