All companies are to some extent affected by the "big picture" backdrop the state of the economy in which they are operating. As a result, understanding the "business cycle" the ups and downs typically endured by an economy over the long run can be very useful for investors.
Some sectors ("cyclical businesses" such as housebuilders or industrial groups) do well in boom times, only for profits to dry up when recession hits. Others ("defensives" such as utilities or companies that sell necessities) enjoy fairly stable earnings almost regardless of the economic conditions. So if you can figure out which phase the economy is going through, you should in theory be able to switch to the sectors best-placed to profit from these shifts.
For example, as Lisa Emsbo-Mattingly of Fidelity notes, the early phase of the business cycle where an economy is just emerging from recession is usually marked by low interest rates, rebounding business activity, rising sales, widening profit margins, and rising credit growth. People have more cash to spend, which is good news for firms that make luxury items, for example.
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Financial stocks meanwhile benefit from rising interest rates and a recovery in lending, while highly cyclical sectors such as industrials see earnings rebound sharply, at a time when their share prices are generally still low post-recession. Defensives struggle because their income remains constant, while their share prices will have been relatively high during the recessionary phase.
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As the cycle matures and the economy strengthens, the earnings of cyclical stocks continue to rise. However, much of this good news will already be priced into the market, and while defensive shares will continue to do badly in relative terms, stocks overall tend to be "fairly strong" during the mid-cycle phase, with no stand-out sector leader, notes Fidelity. Towards the end of the cycle, growth slows, even as inflationary pressures build. Materials and energy stocks do well in this phase, while defensives start to rally as fears of a slowdown grow. Finally, the recession phase mainly benefits defensive stocks.
It sounds good, and it's a recognisable, logical representation of the way that an economy operates. As with many cycle-based theories, however, it can be tricky in practice to work out exactly when a shift is coming. For example, interest rates look likely to rise in the US now but are we really in the early cycle? Or is this the late stage? So rather than try to reallocate your portfolio religiously along these lines, we'd just add an awareness of the business cycle to the tools you use when weighing up whether or not to invest in a sector or share.
