The Chinese stock market crash was a week of panic and pandemonium for most investors. Some investors, though, were cool and composed during Black Monday. They put their money in industries that were poised to benefit during an economic slowdown. Meet the business cycle investors.
Investors who follow the business cycle focus on the performance of industrial sectors instead of individual stocks. Each industrial sector performs differently during a business cycle. Business cycle investing is common sense. When economic growth is strong, you can do well investing in retailers and the automotive industry. When economic growth is stagnant, you will do better investing your money in discount retailers and asset recovery specialists.
If you are saving for retirement, you may want to keep your money parked in your retirement savings funds for 30 years. If you do want some more growth from your portfolio, one option is to invest in the business cycle. Business cycle investing typically involves a span of one to 10 years.
Closely following industries is the best way to get the rhythm of business cycle investing. A business cycle is an economic cycle consisting of two major phases – an expansion and a contraction. Since 1945, there have been 11 business cycles. A business cycle can last many months or years.
During an economic expansion, gross domestic product (GDP) increases. Certain industry sectors experience an increase in productivity signalling the beginning of an expansion. A period of economic growth follows.
An economic contraction starts when the economy enters a recession. Economic activity slows down as the productivity of the economy slows.
The Four Business Cycle Stages
The business cycle model starts at the bottom of the cycle – a recession. Currently, global economies are recovering from the 1998 recession.
- Business Cycle Stage 1 – Recession
Commodity sector growth is strong in the late stage of a business cycle. This growth is often curtailed by a tightening of credit in the economy. Business cycle analysts saw trouble as more oil and gas projects turned to high yield junk bonds for financing in the year leading up to Black Monday. As commodity prices declined but the cost of financing rose, the energy sector’s profit margins were squeezed.
GDP is declining.
Credit availability is very tight.
Productivity and profits are declining.
Sales are declining.
Defensive sectors will continue to do well in a recession and during all stages of the business cycle. They include the health care, consumer staple and utility sectors.
Where to invest: Stocks and commodities do poorly. Bonds are a safe investment.
- Business Cycle Stage 2 – Early Cycle
In the early phase of the cycle, interest rates are low. Consumers and businesses are able to borrow at low rates. The availability of cheap credit helps stoke spending and growth in the economy. The consumer, information technology, industrial, and financial sectors do well as consumers and businesses expand their credit and spend more money.
GDP and other economic indicators (productivity, employment retail sales, etc.) begin to rebound.
The expansion of credit makes more money available in the economy and businesses and consumers spend more.
Industrial productivity and profits increase.
Where to invest: Commodities may be sluggish. Stock market performance is strong. Bonds do well.
- Business Cycle Stage 3 – Mid Cycle
As the economy continues to grow, the central bank will begin to increase interest rates. Growth begins to ease slowly in interest rate sensitive sectors. Information technology does well.
Growth begins to peak.
The credit expansion continues.
Industrial productivity and profits peak.
Sales continue to grow.
Where to invest: Stock market performance is fairly strong. Commodities do well. The energy and materials sectors are growing.
- Business Cycle Stage 4 – Late
All of these signs were present in the Chinese economy before the stock market crash.
GDP begins to slow.
Credit availability tightens.
Industrial productivity and profits slow.
Where to invest: Stock market performance is positive but returns an average of 5% or less. Bond market returns are low but bonds still provide a safe haven. The demand for commodities may still be strong but keep an eye on whether it is more expensive for companies to finance growth. Mid-to-late cycle is a good time to switch into index funds.
Leading and Lagging Indicators
Leading indicators provide advance information on a change in the economy. For example, when manufacturers’ new orders increase, increased productivity follows. More people are put to work to fill the orders, and the wealthier consumer spends more money on retail sales. Lagging indicators such as the unemployment rate and a change in consumer prices show up in the economy in the months after an economic downturn.
The OECD provides a list of Asian Business Cycle Indicators by country. While Singapore’s service economy places emphasis on retail sales, construction and air travel, China is more concerned with its large manufacturing economy and imports.
Other Industry Dynamics
The business cycle provides a guide on economic cycles. At any stage of the business cycle, other industry or macro dynamics can affect the performance of an industry sector.
– Inflation can have a strong effect on an industry’s performance, separate from the business cycle. When prices rise, sales slow.
– A price increase in a key input commodity can lead to a decline in profits and even bankruptcy. Examples are high fuel prices in the airlines industry, or high silicon prices in the solar equipment and semiconductor industries.
– An economic decline in a major market of a supplier. Many commodity sectors declined when China’s economic growth slowed.
– A natural disaster or terrorist event can affect the profitability of a sector. Following the terrorist attacks in Paris, European travel industry-related stocks declined.
There are many tools for tracking business cycles. Here’s a practical approach that may already be in your investment portfolio. Stockcharts.com has plotted industry sector performance by industry ETFs to determine what stage of the economic cycle the US is currently in. This analysis shows the economy in the later stages of an expansion in which the health care and materials sector should do well.
Holding a diversified portfolio of ETFs, or individual ETFs that are highly diversified, is a good way of tracking the business cycle while diversifying risk across industry sectors.