The economy is still in a state of flux, going through periods of growth and recession, and after the two of them, a full economic cycle is over. This cycle can be broken down into four stages: beginning, middle, end, and recession, each prompting distinct investment tactics to capitalize on the phase and direction of the economy. “As the business cycle progresses, different sectors of the market tend to outperform their counterparts,” says Joel Hardin, senior partner and co-founder of City Center Financial in Troy, Michigan.
Business cycle investing attempts to exploit these disparities in performance by overweighting stocks in sectors that have historically performed better during this phase, Hardin said. To do this, investors need stakes in at least four or five economic sectors, with allocations that change as the cycle progresses.
The difficulty lies in correctly identifying the cycle in which the economy finds itself. If you’re wrong, you could have an inconsistent investment strategy, says KC Ma, Roland George president of applied investments and director of the George Investments Institute in DeLand, Florida.
Know the winners of each phase. For example, in the initial phase, when the Federal Reserve generally has loose monetary policy to encourage business growth and full employment, economically sensitive sectors – technology, industry, and finance – have historically performed well. The same goes for sectors that benefit from rising interest rates, such as financials and consumer discretionary.
Halfway through, as abundant jobs produce higher incomes and, as a result, higher expenses, finance and technology continue to thrive, with the industrial sector often outperforming as well.
History 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 blight, restricting credit and thereby reducing the borrowing capacity of businesses and consumers. High commodity prices are also starting to take their toll, and consumer spending is slowing.
Without the stable revenues they enjoyed, companies start cutting costs late, often in the form of jobs. Employment levels fall, leading to lower household incomes, and consumer spending falls even further. In the past, this late phase has been when materials, consumer staples, energy and healthcare performed best, as investors start to feel the economic slowdown and flock to more sectors. stable.
No longer supported by strong demand, prices fall and the rate of inflation slows, slowing the economy even further, until it eventually goes into recession. Defensive sectors like Consumer Staples and Health Care tend to perform best in this phase. Likewise, telecommunications and utilities have performed well as investors are drawn to their more stable incomes. and healthy dividends.
In response to the slowing economy, the Fed may try to rekindle the fire by easing monetary policy. Then the cycle begins again.
Take your benchmarks from economic indicators. According to Rick Welch, president and chief investment officer of Academy Wealth Advisers in Penns Park, Pa., It’s best to invest in the business cycle. Welch, who has been investing in the business cycle with clients for six years, says ETFs are much easier to manage and maintain diversified than individual stocks. Using a single company with ETFs in all or most sectors – such as State Street or Vanguard – can make sector rotation even easier, he says.
The key is to invest a cycle phase in advance. “Investors need to have a forward-looking mindset so that they can prepare their portfolios to capitalize” on the next phase, says Ma. For example, if you think the economy is in a late phase, you must invest for the final phase – the recession – and focus on the sectors that are generally most resistant to a shrinking economy.
But how can you be sure which phase of the cycle you are in so that you know which 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 it’s not easy to gauge the economy. “It takes intuition. It takes reading and study, and very good guesswork, ”he says. Even experts disagree on which phase of the cycle the economy finds itself in.
Welch believes the business cycle is currently in the mid-to-late stage, while Hardin says the consensus is that we are in the late stages of the mid-stage. To add to the confusion, the length of a phase varies. Ma, for example, says we are in an extended late cycle.
Build in a buffer. Because there is no exact science to pinpointing the right phase, Welch says investors should aim to always have weights in all sectors. This way, if a sector experiences an unexpected growth spurt or a dramatic decline, your holdings will not be affected generally. But even if an investor could be 100% certain that the economy would be at some point in the business cycle ahead of time, “he will still have to speculate as to whether investor sentiment and market prices will end up being overwhelming. agree with them, “Hardin said.
Another challenge is that business cycle investing is based entirely on how sectors have performed in the past, Ma says. At any given phase, a sector could behave differently from the long historical average. term, he warns. Due to the frequent turnover that this investment strategy requires, investors may also incur higher transaction costs or excessive management fees if an advisor implements the strategy for them.
To reduce costs and risk, Hardin says investors should use a primary or satellite strategy in which 80% of the portfolio is passively invested in low-cost index funds with the remainder invested based on sector rotation.
Ultimately, investing in the business cycle is a guideline, not a hard and fast rule, Welch says. Investors must allow themselves some latitude to adapt to current market and economic conditions. For its clients, Welch aims to remain between 3% and 5% of the S&P 500 sector weightings, with quarterly adjustments to portfolio allocations as necessary.
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Stock market information as of October 20, 2016