Business activity tends to go in cycles, and under-standing the stages of a business cycle can provide clues that may help you identify favorable investment opportunities. While some stocks tend to be immune to economic swings, others perform better or worse during different stages of the business cycle.
The business cycle can provide insight, but it is important to realize the U.S. economy rarely follows this cycle precisely, and the amount of time spent in each stage of the cycle varies. In addition, the economy does not always expand to its fullest levels, nor does it always dip into recession. It does, however, tend to proceed through six typical stages. Here are some general guidelines to which market sectors are inclined to benefit in each cycle.
- Stage 1: economic slowdown. In a period of economic slowdown, utilities and financial company stocks usually react favorably as it becomes clear to investors that the economy is sluggish. Long-term interest rates peak, and shorter rates begin to fall as the Federal Reserve implements strategies to stimulate the economy.
- Stage 2: anticipated recovery. With anticipated economic recovery, consumer stocks typically rise, as low interest rates encourage consumers to spend more. Stock prices are generally very low during this stage of the economic cycle.
- Stage 3: mid-cycle recovery. In a mid-cycle recovery, interest rates begin to go up, and early signs of inflation emerge. At this stage, stocks generally perform better than bonds. Industrial companies, such as electrical equipment, machinery, and construction come into favor.
- Stage 4: full expansion. During the full expansion stage of the business cycle, interest-rate sensitive stocks generally peak by the time the cyclical expansion is fully under way. Opportunities may appear among companies that benefit during higher inflation and in higher interest-rate environments, such as chemical, technology and energy stocks.
- Stage 5: economic peak. At the economic peak of the cycle, the major stock market indexes may dip below their 12-month moving averages. Basic materials companies (including chemicals and metals) and energy stocks are often favored by investors since inflation is probably peaking during this cycle.
- Stage 6: economic decline. When the business cycle reaches economic decline, investors attempt to protect their portfolios as the economy slows by moving back into early-cycle stocks, beginning with consumer non-cyclicals, which are companies that sell products and services whose demand is not tied to the economic cycle.
While tracking the business cycle can be a useful barometer for investors, keep in mind the business cycle is not precise. In addition, pinpointing particular stages of economic activity is not always easy and even economists do not always agree on exactly where the economy stands in any particular cycle. IBI
