A Cyclical Guide to CEF and ETF Investing

by: Joe Eqcome

Summary: There have been 17 stock market cycles (April ’42 first trough) and 12 US economic cycles (Oct ’45 first trough) since the early 1940s.

While each stock market and economic cycle is different due to its underlying economic fundamentals, one thing is constant: the stock market recovers prior to the general economy as investors discount economic events. The average stock market trough precedes it economic counterpart by 14 months with a median lag of 6 months.

Stock Market and Economic Cycle Interplay: While acknowledging there is no such thing as a typical stock market/economic cycle—particularly with regards to their interaction, the chart below is a graphic depiction of the stock market sectors’ response to a normal cyclical economic contraction and expansion.

Invest by the Numbers: Each of the market sectors are numbered and indicate at which point in the market cycle(s) the sector’s value may be maximized.

In a typical economic contraction production declines triggering lower interest rates. As rates decline, money becomes more available and cheaper for businesses to borrow to fund their enterprise. Lower interest rates have a tendency to benefit financial stocks (#4) and rate sensitive securities (fixed-income).

As production ramps up, transportation stocks (#8) rise as goods begin to move through the economy. This in turn triggers technology spending (#5) and business investments (#7). As the business cycle matures, investors’ shift their investments away from production to storehouses of value to preserve gains, i.e., precious metals (#11).

Recent Cycles: The previous economic cycle troughed in November ’01 and was generally attributed to the “dot.com” bust. The subsequent recovery in technology was less than robust. The current economic bust is financial in nature. It is only rivaled by the Great Depression. This could cause the typical stock recovery to play out differently for financial and related sectors.

Nonetheless, most pundits agree the stock market probably reached its current trough in March ’09. So, barring a double dip recession, we are well into the early stages of a stock market recovery.

ETF and CEF Cyclical Investing: ETFs are probably the best vehicle for this type of investing. Most ETFs are stock indexes of a wide variety of stock sectors and seem an almost perfect vehicle to be utilized for cyclical investing purposes. Click here for MSN Exchange Traded Funds (ETFs) Performance Tracker

Closed end funds (CEFs) are not as conveniently organized as ETFs for this purpose. Approximately two-thirds of CEFs by number are fixed-income related. As previously noted, this sector typically does well in the early phase of a stock market recovery. In fact, CEFs on average are up almost 40% YTD.

The equity-oriented CEFs are not classified in a fashion that makes them readily comparable to the market sectors in the chart above. Unlike ETFs that have a dedicated focus, the portfolios of equity CEFs can be broadly diversified and can employ leverage. In fact, CEFs are probably best analyzed in a “bottoms-up” fashion (focusing more on the characteristics of the individual CEF) than a “top down” fashion consistent with sectors analysis.

Handy-Dandy CEF Guide: The following is a handy-dandy guide of CEFs characterized in the broad classification consistent with the market sectors depicted in the chart above. This was a “push”. Sectors highlighted in tan in the chart below are ones in which there is a higher degree of confidence of their compatibility. This may or may not be helpful in adjusting CEF portfolio weighting as the stock cycle advances through its phases.

Consider it just another piece of information to be stitched together with other information to create a mosaic for CEF investment decision making.