The economy is always in a state of flux, moving through periods of growth and recession, and after both, a full business cycle is complete. That cycle can be broken down further into four stages: early, mid, late and recession, with each prompting separate investing tactics to capitalize on the economy’s phase and direction. “As the business cycle progresses, different market sectors tend to perform better than their counterparts,” says Joel Hardin, senior partner and co-founder of City Center Financial in Troy, Michigan.
[See: The New Sector Funds: 10 Thematic ETFs.]
Business cycle investing attempts to exploit these performance disparities by overweighting stocks in sectors that historically have given better returns during that phase, Hardin says. To do this, investors need holdings in at least four or five economic sectors, with allocations that are rotated as the cycle progresses.
The difficulty lies in correctly identifying which cycle the economy is in. Get it wrong and you could have a mismatched investment strategy, says K.C. Ma, the Roland George chair of applied investments and director of George Investments Institute in DeLand, Florida.
Know the winners of each phase. For instance, in the early phase, when the Federal Reserve usually has a loose monetary policy to encourage business growth and full employment, economically sensitive sectors — technology, industrials and financials — historically have performed well. The same is true for sectors that benefit from rising interest rates, such as financials and consumer discretionary.
In the mid phase, as plentiful jobs produce higher incomes and consequently greater spending, financials and technology continue to thrive, with the industrials sector also often outperforming.
The story changes in the late phase as the economy begins to overheat. The Fed may raise interest rates at this point to help slow the economic burn, restricting credit and thereby reducing the ability to borrow for both businesses and consumers. The high prices of goods begin to take their toll as well, and consumer spending slows.
Without the steady revenue they had been enjoying, businesses start cutting costs in the late phase, often in the form of jobs. Employment levels drop, prompting household incomes to decline, and consumer spending falls even more. In the past, this late phase is when materials, consumer staples, energy and health care have performed best, as investors begin to sense the economic slowdown and flock to more stable sectors.
[See: 7 Stocks to Buy When a Recession Hits.]
No longer buoyed by high demand, prices drop and the inflation rate decreases, slowing the economy even further, until it ultimately falls into recession. Defensive sectors like consumer staples and health care typically perform best at this phase. Likewise, telecommunications and utilities have done well because investors are drawn to their more stable revenue and healthy dividends.
In response to the lagging economy, the Fed may try to reignite the fire by loosening its monetary policy. So the cycle begins again.
Get your bearings from economic indicators. Business cycle investing is best done using sector exchange-traded funds, says Rick Welch, president and chief investment officer of Academy Wealth Advisers in Penns Park, Pennsylvania. Welch, who has been doing business cycle investing with his clients for six years, says ETFs are a lot easier to manage and keep diversified than individual stocks. Using one company with ETFs in all or most of the sectors — such as State Street or Vanguard — can make sector rotation even simpler, he says.
The key is to invest one cycle phase ahead. “Investors need to have a forward-looking mindset so they can prepare their portfolios to capitalize” on the next phase, Ma says. For example, if you believe the economy is in the late phase, you should invest for the final phase — recession — and emphasize sectors that typically withstand a contracting economy best.
But how can you be sure which cycle phase you’re in so that you know the sectors to overweight or underweight at any given time? To get your bearings, Ma suggests looking at economic indicators such as the Fed’s monetary policy, credit availability, inventory levels, corporate profits and employment numbers.
The stock market and individual sector performance also provide clues, Welch says, but gauging the economy isn’t easy. “It takes intuition. It takes reading and study, and some really good guesswork,” he says. Even experts disagree about which phase in the cycle the economy is in.
Welch believes the business cycle is currently in the mid to late phase, while Hardin says the consensus is that we are in the later stages of the mid phase. Adding to the confusion is that the length of time any phase lasts varies. Ma, for instance, says we have been in a prolonged late cycle.
Build in a buffer. Because there’s no exact science to identifying the correct phase, Welch says investors should aim to always have weightings in all of the sectors. This way, if one sector has an unexpected growth spurt or a dramatic decline, your holdings won’t get hit across the board. But even if an investor could be 100 percent certain that the economy would be at a particular point in the business cycle ahead of time, “they are still going to have to speculate as to whether investor sentiment and market prices will eventually agree with them,” Hardin says.
Another challenge is that business cycle investing is based entirely on how sectors have behaved in the past, Ma says. At any given phase a sector could perform differently from the long-term historical average, he warns. Because of the frequent rotation this investing strategy requires, investors may also incur higher transaction costs or excessive management fees if an advisor implements the strategy for them.
To keep costs and risk down, Hardin says investors should use a core or satellite strategy in which 80 percent of the portfolio is invested passively in low-cost index funds with the remainder invested based on sector rotation.
[See: High-Tech Investing: 7 Sectors to Watch.]
At the end of the day, business cycle investing is a guideline, not a hard and fast rule, Welch says. Investors should allow themselves some room to adjust to current market and economic conditions. For his clients, Welch aims to stay within 3 percent to 5 percent of the S&P 500’s sector weightings, with quarterly adjustments made to portfolio allocations as needed.
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How to Invest With the Business Cycle originally appeared on usnews.com
