What the Business Cycle Says About Industry Stock Performance
The stock market is a dynamic entity that’s in constant motion. Investors analyze stock movements across various sectors in an attempt to spot trends and predict future patterns. One of the most often used methods for analyzing stock patterns is the business cycle.
As the economy ebbs and wanes, certain sectors of the stock market outperform or under-perform. The business cycle tracks these movements and creates a generally recognized pattern that investors can use to identify winning sectors. By identifying where the economy is at in the cycle, investors can narrow down their search to those sectors that are expected to perform well.
Tracking the Business Cycle
There are four main stages of the business cycle: early expansion, mid-expansion, late expansion and recession. Let’s take a closer look to see what events occur during each stage and which industries outperform.
In this stage of the economy, a recovery from a recession is well under way with inflation turning positive and manufacturing production rising. Monetary policy changes to ease credit conditions, allowing for growth in profit margins, while low business inventories set the stage for high sales growth.
The sectors that perform best during this stage are consumer discretionary, financials, industrials and technology.
The middle part of economic expansion is usually the longest-lasting phase with the economy establishing a solid growth rate. Credit remains relatively easy with businesses increasing profit margins, while inventories and sales growth reaches a balanced state.
Most non-defensive sectors perform well during this stage, with few sectors emerging as true leaders. Sector investing is least effective during this stage and investors should focus on identifying trends within sectors.
The economy hits its peak in the late expansion phase with growth beginning to slow down. Inflation peaks and monetary policy switches to a restrictive environment, raising interest rates. Profit margins decline, while sales growth slows down with business inventories beginning to rise.
Energy and materials are typical out-performers during this stage, benefiting from inflation. Defensive sectors begin to become more popular, as well, with consumer staples, healthcare and utilities attracting investments.
The economy retracts during this stage of the cycle with credit availability reaching its lowest point. Business margins plummet, while inventories slowly begin to fall, until an equilibrium with sales is reached.
Defensive sectors, such as consumer staples, healthcare and utilities outperform during this stage, as they produce goods and services that have a steady demand unrelated to economic performance.
While the business cycle can help you find what sectors should outperform, it only helps on a macroscopic scale. In other words, it won’t help you find trends within an industry or tell you what stocks within an industry are considered best-in-class. Some industries, like biotechnology, don’t follow along the business cycle at all, so over-relying on it could mean that you miss out on other opportunities.