Sector Rotation Confirms ABCT

by: Roger McKinney

Mark Skousen in his excellent economics text, The Structure of Production, shows that professions on the front line such as accountants and investing experts, follow the Austrian business-cycle theory (ABCT) often without knowing it. Schwab confirmed that in March of this year with a chart titled "The Business Cycle: How Does Each Sector Perform."

The chart divides the business cycle into four segments - early expansion, maturing expansion, late expansion and recession - and shows which sectors perform the best in each segment of the cycle. I do something similar in Financial Bull Riding, but use segments of the cycle described by Lord Overton in the mid-1800s.

In the early expansion segment of the cycle, the consumer discretionary and industrials sectors perform the best. Information technology does best in the next segment. Financials, energy, and materials perform the best in the last stage of the expansion. There is some overlap between segments exist.

If you expect a recession, the defensive stocks are in the consumer staples, telecomm, utilities and healthcare.

If you would like greater detail, Fidelity Investments came out with a similar report in 2014 that it called "The Business Cycle Approach to Equity Sector Investing." Fidelity wrote, "Over the intermediate term, asset performance is often driven largely by cyclical factors tied to the state of the economy, such as corporate earnings, interest rates, and inflation." In fact, I would bet that after removing the business cycle effect, there is little alpha left in picking individual stocks.

The Fidelity divides the business cycle in the four segments, also, and makes similar recommendations as Schwab. But Fidelity offers more detailed explanations as to why each sector does so well in those segments. Their data only goes back to 1962, but the evidence for the outperformance by each sector in its phase of the cycle is very strong.

If you're domestically partnered to the Efficient Market Hypothesis or behavioral finance, this sort of analysis will seem like voodoo to you. But it is old news for good financial experts while still new to most investors and all academics. The difference between academics and professionals is that academics can be wrong for decades, and have been, because their bad theories hurt someone else and not the academics. If financial professionals are wrong, they lose their jobs or businesses, so they can't afford to be wrong.

Also, sector rotation provides sound empirical support for the ABCT if investors are looking for it. On the other hand, the ABCT provides the economic theory to support sector rotation strategies.

The only thing I would contribute is that investors should consider bonds as their defensive strategy. As Fidelity wrote, "In contrast, more defensive assets such as Treasury bonds typically experience the opposite pattern [to equities], enjoying their highest returns relative to stocks during a recession..."