The business cycle is the collection of stages that an economy goes through as it expands, slows down, and declines. These "cycles" repeat, and investors who understand where the economy is situated within the business cycle can better position their portfolios by investing in securities that benefit from the unique characteristics of each stage.
There are benefits and risks to following this approach, and determining the economy's position in the business cycle can require some analysis by the investor. Investors who devote time to evaluating the business cycle for themselves can attempt to earn higher returns and potentially avoid some of the risks of investing in shares, sectors funds, and ETFs at times when they are less likely to perform well.
Beginning the cycle
The business cycle is considered to "begin" as the economy is rebounding from recession. Economic activity begins to pick up, which can be seen through growth in Gross Domestic Product (GDP), reported company profits, and employment. Businesses can generally keep low inventories and see rapid sales growth during this stage. Additionally, fiscal and monetary policy may still be "stimulative," which provides a further boost to the recovery.
During this phase, the leading economic sectors are those that are more sensitive to changes in interest rates, such as consumer discretionary and financial stocks.
Other companies may be boosted by the shift from recession to recovery. Economically sensitive sectors like industrials, information technology, and materials are typically strong performers. Utility and telecom stocks—which are more defensive in nature—may not perform as well during the early recovery, at least compared to more cyclical sectors, because their returns are less sensitive to changes in the business cycle.
Moving through the cycle
As the economy pushes forward through the initial recovery, growth rates tend to moderate, and the price performance of many stocks may taper off. This phase has tended to be the longest phase of the whole cycle, with different sectors having outperformed at different times. Information technology stocks have historically earned strong returns during this phase. Certain industries within the technology sector, such as software, computers, and peripherals, tend to outperform in particular, as other companies are more willing to spend capital and buy their products. Additionally, companies in the industrials sector are not consistent outperformers, but historically do tend to fare well in these mid-cycle expansions.
The utilities and materials sectors can show lackluster performance in these environments, as they tend to lag behind the broader market. However, since there can often be a lack of clear sector leadership in these environments, investors may want to be extra careful with their sector allocations.
Toward the end
The sustained growth in economic activity will tend to mature and slow toward the end of the economic cycle. Inflationary pressures may build in these phases, which can lead to outperformance from companies in the energy and basic materials sectors. As investors begin to see signs of an economic slowdown, defense-oriented sectors (such as health care, consumer staples, and utilities) have the potential to outperform the market.
Information technology and consumer discretionary stocks tend to lag behind the broader market in these environments, as investors shy away from economically sensitive areas.
Heading into recession
Recessions are generally the shortest phase of the business cycle but can be a trying period for investors. During these periods, credit contracts, sales tend to slow, and it can be difficult for certain businesses—particularly those that are more economically sensitive—to thrive. The broader market lost an average of 15% a year during these periods.1
Those sectors that are not as sensitive to the broader economic environment can be a bright spot, however. Sectors like consumer staples, utilities, telecommunication services, and health care may attract investors. Since they produce items that consumers are unlikely to cut back on as much—like toothpaste, phone service, electricity, and prescription drugs—they have less sensitivity to a decrease in consumer demand than companies in other sectors.
In particular, the consumer staples sector has outperformed the broader market during every recessionary period,2 because businesses in these sectors are comparatively isolated from cyclical changes in demand. Other sectors with similar characteristics—utilities and telecom stocks—have frequently outperformed. The comparatively high dividend yields associated with utility and telecom stocks can also underpin these sectors when current income is in demand by investors.
Why keep the business cycle in mind?
There is historic evidence that certain companies in specific sectors exhibit relative outperformance at different times in the business cycle. By understanding how certain companies and sectors react to the business cycle, investors may be able to position their portfolio with securities or funds that have a strong probability of outperforming the rest of the market.
Investing with a more intermediate time frame using the business cycle has some advantages over attempting to trade more short-term strategies. For many investors, it can be more practical to implement a sector-based approach to the business cycle, rather than trying to make tactical short-term moves, because of the risk of actively trading stocks that may move quickly in the opposite direction—a phenomenon sometimes called "getting whipsawed."
Incorporating a sector analysis, and a more granular industry-level analysis, can further aid the investment decision-making process.
Every business cycle has differences, yet they share the common phase structure. Using a disciplined investment framework that incorporates knowledge about the different phases, investors may be able to identify where we are in the business cycle to improve the portfolio construction and asset allocation process.