Market Sectors & Economic Cycles
Individual market sectors will outperform the stock market at various stages of the economic cycle. An important aspect of asset allocation and diversification is to ensure that a portfolio includes stocks that will perform well throughout the various stages of the economic, or business cycle. At Global Asset Management we employ this strategy to minimize both risk and volatility for our clients.
How Economic Cycles Affect the Markets
Economic cycles and market cycles are different. Understanding the difference and how this impacts investment performance is fundamental to establishing the optimal structure of a portfolio.
Technically speaking, the market refers to the capital markets. These include all the trading arenas for buying and selling securities, and includes stocks, bonds and derivatives, among others. Capital markets are made up of all investors: individuals, pension funds, banks, insurance companies, hedge funds and mutual funds. Collectively, their behavior influences the performance of the various capital markets. Market cycles refer to the repeated patterns of behavior of the stock markets.
The economy refers to the components of an economic system. It can refer to a national economy, a local economy or the global economy. It includes consumers, businesses, corporations, governments and financial institutions. What is happening in the economy is reflected by prevailing interest rates and statistical data like employment rates and consumer confidence, all of which can have a major impact on financial markets. However, markets often move ahead of economic indicators which is why it difficult to time the market. Bull markets usually peak ahead of the economy, and bear markets can begin during periods of economic growth. When the Fed declares a recession and lowers interest rates, this is once again bullish for the markets.
Sector Performance During Each Phase of the Business Cycle
Early-Cycle: This is when the economy is recovering from recession. At this point, monetary policy is still injecting money and liquidity into the economy and interest rates are lower. This stimulates economic growth. We see increases in company earnings and consumer spending. Sectors that do well are financials and consumer cyclicals. The bond market is strong since low interest rates are bullish for fixed income products.
Mid-Cycle: During this phase, the economy is strongest, but the rate of growth is slowing. It’s the longest phase in the business cycle. Corporate earnings peak and interest rates tend to bottom. Sectors that do well during this phase are basic materials, industrials and technology. The bond market will start to lose steam since interest rates steady themselves and the Fed may begin increases to head off inflation.
Late-Cycle: At this phase, economic growth starts to seem overheated and there may be signs of inflation which will be met with tightening measures by the Fed. P/E ratios are highest since stock prices are higher relative to earnings. Sectors that do well during this phase are consumer staples, healthcare, utilities and energy.
Recession: During a recession phase, the economy is contracting, and corporate earnings and profits are on the decline. Interest rates will have peaked and will start to fall as the Fed once again injects liquidity to stimulate the economy. The stock market will decline, either gradually or with a major correction. Consumer staples, healthcare and utilities will continue to do well during this phase. Historically, this is the shortest phase. Upticks in consumer cyclicals are the first sign that the economy has gone full circle and returning to the early-cycle phase.