The business or economic cycle consists of the fluctuations of activities within an economy. Many investors believe this is one of the primary factors that drive equity price performances over the intermediate-term time horizon. The challenge of sector allocators or rotators is to successfully identify the sectors that will outperform during the different phases of the economy.
Over the intermediate term, performance is influenced heavily by the cyclical factors in the economy, such as interest rates, commodity prices, inflation, deflation, etc. The business cycle then represents the cyclical fluctuations in the economy over many months, quarters, and even years.
Every business cycle is different, but certain patterns tend to repeat themselves. The phases of an economic cycle are early-cycle, mid-cycle, late-cycle, and recession/contraction.
The early cycle occurs when economic activity rebounds, credits grow, profits grow, monetary/fiscal policy is stimulative, inventories are low, and sales improve. The mid-cycle phase is when growth peaks, credit growth remains strong, profit growth peaks, monetary/fiscal policy is neural, inventories and sales continue to grow. The late-cycle arises when growth moderates, credit tightens, earnings pressured, monetary/fiscal policies subside, inventories increase, and sales growth declines. The recession/contraction phase appears when economic activity falls, credit contracts, profits decline, monetary/fiscal policies ease, and investors and sales fall.
The stock market cycle tends to discount the business/economic cycles. Because the stock market is a leading indicator of economic activities, it tends to lead by months or quarters in advance of a peak or trough in the business cycle. Historically, the early-cycle tends to generate the highest returns. Economically sensitive and interest rate sensitive sectors tend to excel during this phase. For instance, consumer discretionary, financials, real estate are relative outperformers. Other economic sectors such as industrials, materials, and some technology also excel into the later stages of the early-cycle phase.
We recommend traders and investors monitor the relative and absolute performances from economically and interest rate-sensitive sectors as weaknesses here warn of the next economic phase and the next sector rotation.
The mid-cycle phase tends to produce strong market returns, but not as strong as the early-cycle phase. At this point in the cycle, economically sensitive and interest rates sensitive sectors have already outperformed their peers as they begin to lose relative strengths and price momentums. As the expansion phase gains traction, sector rotations become more violent and volatile. Stock market corrections become more frequent than the prior cycle. The mid-cycle phase tends to be the longest of the economic cycle.
We may be moving into this stage, possibly during the second half of the year. The Technology sector tends to excel during this phase of the economic cycle.
Semiconductors and Hardware also lead within the Technology sector, probably because confidence in the economic recovery is strong and companies are more willing to spend via capital expenditures.
Communication Services is another sector that tends to outperform peers due to the concentration of technology-related names and improving business outlook in the media and advertising industry.
We will defer our discussion of the late-cycle and the recession/contract phases for another time. However, as the economic recovery matures, commodity-based sectors such as Energy and Materials tend to excel. Also, less economically sensitive sectors such as Health Care, Consumer Staples, and Utilities begin to improve from a relative strength perspective. The recession/contraction phase tends to be the shortest of the economic phases, typically lasting for less than 1-year. As economic activities contract, defensive, income-producing, and lower-beta sectors such as Consumer Staples, Utilities, and Healthcare take on sector leadership roles.