Raleigh NC Financial Advisor: Business Cycle Investing
To choose investments wisely, it's crucial to understand how stocks and bonds perform during different stages of the business cycle. This knowledge helps in making informed decisions regarding smart investments.
Knowing the business cycle helps investors manage their investments better as the chances of moving from one phase to another increase. This way of investing in business cycles is different from short-term and long-term strategies. Historical data shows that shifts between business cycle phases happen every few months or years on average.
Business Cycle Phases
While each business cycle is unique, certain patterns tend to recur over time. These patterns are reflected in changes in corporate profits, credit availability, inventories of unsold goods, employment, and monetary policy.
Unexpected events can sometimes disrupt these trends. However, these indicators have typically been reliable in identifying the various phases of the cycle. However, it is important to note that the duration of each phase can vary significantly.
A typical business cycle comprises four distinct phases:
Early cycle: This phase is characterized by a sharp recovery from a recession. Economic indicators, such as gross domestic product and industrial production, shift from negative to positive, and growth gains momentum. Increased credit availability and low interest rates support profit growth. Business inventories are relatively low, and sales experience significant growth.
Mid-cycle: Usually the longest phase of the cycle is marked by moderate growth. The economy is getting stronger, credit is growing, and businesses are making good profits as the government changes its monetary policy.
Late cycle: Economic activity often reaches its peak during this phase, indicating that growth is still positive but slowing down. Rising inflation and a tight labor market may exert pressure on profits and result in higher interest rates.
Recession: Economic activity contracts, leading to a decline in profits and scarcity of credit for both businesses and consumers. Interest rates and business inventories gradually decrease, setting the stage for a subsequent recovery.
Investment Performance during each Phase
Investments have had different returns as the economy changes from one stage to another in history. Changes in the economy, technology, regulations, and other factors have caused investments to behave differently in each cycle.
Some stocks or bonds consistently perform well, while others do not perform as well, regardless of the investment cycle. Understanding these distinctions can assist investors in establishing realistic expectations for their returns. Notably, the recent COVID-19 pandemic has significantly impacted investment performance.
Investments in Early Cycle
Since 1962, stocks have demonstrated their strongest performance during the early cycle phase, with an average annual return exceeding 20%. This phase typically lasts around one year on average. Stocks outperform bonds and cash currently due to low interest rates, improving economy, and increased company profits.
Stocks in consumer discretionary, financials, and real estate industries have performed well in the early cycle due to low interest rates. Notably, consumer discretionary stocks have outperformed the broader market in every early cycle since 1962.
Industries that borrow more, like finance, cars, and household goods, have done well in the early cycle. Additionally, high-yield corporate bonds have shown strong annual gains on average during this stage.
Investments in Mid Cycle
When the economy slows down, stocks that are affected by interest rates and overall economic activity tend to do well. Additionally, stocks of companies whose products are in demand once the expansion becomes firmly established have also shown robust returns.
Usually, the stock market does well in the middle of its cycle, with an average annual performance of about 14%. In the past, stocks have given better returns than bonds and cash. However, during the early cycle, the difference in returns between the three has been smaller.
Recently, IT stocks, particularly semiconductor and hardware stocks, have been performing exceptionally well. This is due to companies gaining more confidence in the economic recovery and increasing their investments.
The middle phase is usually the longest, lasting about 3 years on average, and it's when most market corrections happen. During the mid-cycle, no single type of investment consistently outperforms the overall market. Instead, different types of investments tend to have fairly even performance.
Investments in Late Cycle
The late cycle phase usually lasts for about 1.5 years. During this time, the stock market tends to gain approximately 5% per year. As the economy gets better, prices and borrowing costs go up, so investors avoid assets that are affected by economic changes. Longer-duration bonds may face challenges due to higher inflation.
During this period, energy and utility stocks have demonstrated solid performance as inflation rises and demand remains robust. Additionally, cash has tended to outperform bonds. Investors should be careful when changing their asset allocation during the late cycle to find opportunities. Prudent decision-making is crucial given the specific dynamics and risks associated with this phase.
Investments in Recession
In the past, recessions were short, lasting less than a year on average. Stocks had a bad average annual return of -15%. In recessions, interest rates go down, making it a good time to invest in high-quality corporate and government bonds. These bonds have done better than stocks in most recessions.
When the economy shrinks, stocks tied to their health lose popularity, while defensive stocks do well. Defensive stocks are companies that make important things like toothpaste, electricity, and medicine. People usually don't cut back on buying these things during a recession. As a result, the profits of these companies are more likely to remain stable compared to others.
Utility and health care companies, which offer high dividends, have experienced positive performance during recessions. Conversely, interest-rate-sensitive stocks, such as those of financial, industrial, information technology, and real estate companies, have typically underperformed the broader market during this phase.
Bottom Line
Investors can get helpful advice for their portfolios by using an investment analysis method. This method identifies important stages in the economy and looks at how investments have performed in those stages. Every business cycle is different, but this method can still provide valuable insights. As always, you should consult with a financial advisor or financial planner.
Sources:
https://www.fidelity.com/viewpoints/investing-ideas/sector-investing-business-cycle
https://smartasset.com/financial-advisor/business-cycle
Disclosures:
This site may contain links to articles or other information that may be on a third-party website. Advisory Services Network, LLC is not responsible for and does not control, adopt, or endorse any content contained on any third-party website.
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
These are the views of the author, not the named Representative or Advisory Services Network, LLC, and should not be construed as investment advice. Neither the named Representative nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.