Nothing is absolutely predictable but economic cycles tend to follow a somewhat predictable course and within the economic cycle, sectors too fall in line with an element of predictability.
Secular trends can influence how different sectors perform during an economic cycle. For example, if you believe energy has a powerful and sustainable secular force behind it and are correct, energy as a sector will outperform throughout the economic cycle. But this will not change the fact that the most substantial gains will be made by the sector, during its traditional favorable period in the cycle. Sectors follow a cycle; broadly,
- Financials will lead an economy out of recession. As interest rates fall and the yield curve steepens, risk aversion falls and credit availability improves. Credit is the lifeblood of business, and as it expands, a recovery takes hold.
- Technology as an enhancer in productivity takes the next place in the cycle. Investment in productivity enhancement is amongst first investments required following a recovery.
- Consumer Discretionary is the next sector in line. As the recovery takes hold, improving confidence and rising discretionary income create a favorable environment for this sector.
- Initial discretionary spending draws inventory levels down. Wide credit availability backed by discretionary demand and improved productivity create a nice environment for Industrials. And so industrial's is the next cycle beneficiary.
- Expanding demand from the industrial sector creates demand for Materials and this sector stands next in place in the cycle.
- Discretionary spending has led to rising mobility of goods and services. The firing of industrial furnaces creates additional demand for energy. Materials too are an energy intense sector, and demand for materials from industrials creates demand for energy. Energy is the next in the cycle.
- By the time the energy sector leads, it is quite common for growth to have taken hold very firmly. Interest rates will have risen considerably; inflation and inflation expectations will be high. As the yield curve flattens economic risks rise. And as economic risk rise, investors turn defensive. Consumer Staples, the sector which provides low levels of earnings volatility together with reasonable growth is the next in cycle.
- As economic risks continue to rise, Healthcare is next in cycle. Healthcare as a sector provides even lower levels of earnings volatility. In addition, as a sweetener, yields in the sector tend to be healthy.
- Utilities & Telcom are the last in the cycle. These sectors provide stable earnings and the highest yields. During recessions, the demand for safety makes dividends more popular.
The duration of an economic cycle varies; on average an economic cycle will last 67 months. Understanding the cycle is important for all investors. A person with a short term horizon can benefit by buying into a favorable cycle trend by examining where in the cycle we are today. A person with a buy and hold approach can hope to time entry points using a combination of buying value and buying sectors during the cycle phase when they are out of favor. A person with a cycle view can hope to time entry points using a combination of buying value, buying sectors during the cycle phase when they are out of favor and booking profits or exiting positions as a sector concludes its period of outperformance.
And yes, traders can benefit too; as the cycle shifts there is inevitable volatility as a new sector enters its phase of outperformance to replace the prior leader.
If you wish, you can visit MaxKapital.com and download the file Using Economic Indicators on "Quant Report"; this report provides my view of how sectors can be expected to perform during various phases of an economic cycle. For those of you who do visit, in my view we are presently in the middle of phase 2; that is six months into the beginning & early expansion. Remember this; a secular force can negate, subdue or enhance a cycle position.
Cycles are important; in addition to the big picture cycle detailed above, there is an important micro cycle too. For buy side cycle investors, this is an important micro-cycle - it creates some wonderful absolute return opportunities.