The periods we call a market cycle are unique in their length, highs, and lows. What they all have in common are periods of declines, recovery, and growth; each is related to business cycles. It has been proven that it is challenging to time the market exactly right. By timing, I mean completely selling a position and sitting in cash then deciding when to reinvest. Remaining fully invested is the best idea. Knowing when to shift your asset allocation is beneficial. We take clues from the market cycle to know when our shifts should occur.
Let’s start with reflection on an older post that described the Federal Reserve and how interest rate changes impact the flow of money for businesses and individuals. Read the full post here, but here is the quick and dirty:
Interest rates are lowered to encourage borrowing and spending by businesses and individuals.
Expansion: Borrowing and spending make businesses more profitable, people make more, stock prices rise.
Interest rates rise and eventually spending slows down, businesses make less, people make less.
Contraction: Borrowing stops, spending stops, and stock prices fall.
Rinse and repeat.
Here is a graphic of how these contraction and expansion periods impact businesses and the markets:
When interest rates are on the rise, it is because businesses are doing well. When companies are doing well, their profits rise and so will their stock prices. It is called a bull market when there are positive returns from the stocks. Individuals will begin to get paid more if their employer is making more. Everyone is happy!
Times are good, but the value of the dollar begins to deteriorate. When demand is high, the price of goods and services rise, and soon our dollar will buy less than it did previously. We call this inflation.
Interest rates will reach a point when borrowing will slow down and therefore so will spending. No growth phase will last forever. As the growth of businesses slows down, profits will decrease and so will stock prices. No one knows how fast this will occur, sometimes it takes a year or two, and sometimes it will happen over several years. The period of pessimism and negative returns, often characterized by a 20% loss or more, from the stock market is called a bear market.
Here are the stock market sectors that have historically performed well during a bull, or growth, market:
Early phase – a time of recovery from a recession and there is a point where negative returns stop and positive returns begin. This is a period when interest rates stop decreasing, borrowing increases, and economic activity picks up. Sectors to watch would include:
o Consumer Discretionary – borrowing picks up, so consumers spend more on things like hotels or retail items.
o Financial – banks are the bulk of this sector therefore when rates stop decreasing and are preparing to rise we will begin to see positive results from financial stocks.
o Telecom and utility stocks will tend to lag during this phase because they are considered basics or defensive.
Mid-cycle phase – growth rates become moderate, and interest rates may start to rise slowly. Sectors to watch would include:
o Information technology – companies begin to feel confident about the economy and will seek to spend more on software and hardware improvements.
o Industrials – those that produce capital goods benefit when economic growth is underway; demand rises.
o Utilities and materials tend to lag, spending shifts from these necessities to wishlist items for both consumers and businesses.
Late-cycle phase – there are some signs of a slowdown, but economic expansion is still occurring. Investors will begin to look towards dependable sectors that offer basic goods and services. Defensive sectors to watch:
o Healthcare – everyone needs healthcare all the time. Therefore, this is a strong sector when people begin to stop spending money.
o Consumer staples –things we think of as basic goods like groceries and gasoline. People won’t stop spending on basics as opposed to discretionary items like retail goods.
o Energy, Utilities, and telecom – oil and gas companies in addition to water service and electric companies. Businesses and individuals continue to need raw materials and necessities like these, even in times of economic slowdown.
o Consumer discretionary and info tech will lag when businesses and consumers tighten spending.
o Investors will begin moving out of stocks and into safer fixed income securities, such as bonds.
Here are the stock market sectors that have historically performed well during a bear, or down, market:
Recession phase – economic activity has stopped and pulled back. This tends to be the shortest phase. It becomes harder to borrow funds and businesses are losing money and laying off workers. Interest rates will begin to fall. Defensive nature stocks with strong dividends are typically favored:
o As mentioned with late-cycle phase, consumer staples, utilities, telecom services, and healthcare offer basic items to consumers and these sectors tend to be stable in an economy with low activity.
o Real estate, financials, industrials, and info technology tend to underperform during this cycle because they will require borrowed funds from the consumer.
o Investors will favor safer fixed income securities, such as bonds, over stocks.
Educating yourself about the current or shifting business cycle can help you add returns to your portfolio through sector selection. If you are interested and aware of countries that favor the sectors mentioned above, ETFs or exchange-traded funds make it easy to increase a particular country or sector allocation in your portfolio. Subscribing to a newsletter from an ETF provider like iShares can give you insights about a wide variety of sectors and countries.
The key to making good decisions about the stock market is to avoid reacting out of fear or to attempt to perfectly time market movements. Instead, make decisions based on your asset allocation strategy and investment philosophy. Make sure your strategy takes into account your time period and tolerance for risk or losses, and it is reviewed annually. Monitoring your investment returns and your diversification will keep you on track to achieve your goals. See our post on how to monitor your investment portfolio here.
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