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What is the business cycle? And, why does it matter for stock market investing?

  • July 30, 2021
  • Front

In a Nutshell:

Our economy can be defined in four basic phases, expansion, slowdown, recession, and recovery and this is called the business cycle. This means that even after a recession, the economy will bounce back.

Over the last two decades, the U.S. economy has experienced three aggressive recessions: The Dotcom Bubble Burst, the Great Recession, and the COVID-19 pandemic all left their own unique marks on the financial system. And, consequently, they left a mark on all participants in our economy. Millions of people lost their jobs, some companies were forced to close forever, and investors took significant hits to their portfolios.

However, there is a commonality shared across all three of these events: they were short-lived. Within 12 to 24 months, the economy started to bounce back; recovering from the thing that set it off course. As the economy recovered, employment rose, companies continued to grow, and people went back to work.

This is the business cycle. Its four phases define our economy: expansion, slowdown, recession, and recovery. You might be familiar with one or two of these stages already. During expansion, the market grows over a prolonged period of time. Slowdown is the period of time when the market’s growth starts to slow. Recession is a period of prolonged economic weakness. And, finally, there’s the recovery—which puts us right back at the top of the cycle.

The cycle affects the economy, people, and the stock market. That’s why we’re breaking down what the business cycle is and how it impacts various portions of the market.

Breaking down the business cycle for stock market investing

To understand the business cycle and its relationship to the stock market, it might help you to get familiar with the 11 sectors on the stock market. If you’re feeling comfortable with the basics already, let’s jump right in!

As it turns out, there’s a strong relationship between some sectors and different stages of the business cycle. Let’s dig into that a little more and explain why:

Why do certain sectors do better or worse at different times?

So, why do certain sectors do better, worse, or stay the same, depending on where the economy is in the business cycle? Well, that answer depends in part on the sector we’re talking about. However, we can be a little general with our conclusions.

Some sectors generally have strong fundamentals at all stages of the market cycle. Sectors such as healthcare, energy, utilities, and consumer staples can rely on steady income even during an economic downturn. The reason why is simple: it’s reasonable to expect people to keep paying utility bills, buying groceries and food, and paying for doctors’ visits and drugs, even during a recession or downturn.

These sectors are reliable because they sell necessities. However, despite the strong fundamentals they exhibit in times of broader market weakness, these sectors might underperform in other stages of the business cycle as investors look elsewhere for opportunities.

Those opportunities are plentiful in sectors such as financials, real estate, information technology, consumer discretionary, and industrials. These are the sectors that find their momentum early in the business cycle. That’s because, as the economy rebounds, it’s often these stocks that are most well-positioned to capture that growth.

Financials and real estate stocks appreciate as the price of assets rises again, consumer discretionary benefits from increased disposable income among consumers, and other sectors appreciate as they are positioned for robust growth. 

It’s important to recognize that, though certain sectors might be primed for success during different portions of the business cycle, certain companies might not be. These analyses of sectors are just trends that speak to the historical success of certain sectors at certain times. However, they do not necessarily guarantee the success of a sector or companies within it.

Now that you understand which sectors perform well at different stages of the business cycle, you might be wondering: How will I know when we move from one stage to the next? Well, hindsight is 20/20, but let’s evaluate.

How long does each business cycle last?

There are no rules for how long a stage of the business cycle has to last. However, time is on the side of one stage more than any other: the expansion phase. Expansion is generally the longest-lasting stage of the cycle because expansion takes time. That’s not to say that a slowdown or recession doesn’t have an impact on the economy, but it’s to say that it takes time to build something and far less time to break it apart.

The U.S. economy experienced its longest expansion in history from the end of the Great Recession in June 2009 to the start of the COVID-19 pandemic in March 2021. The COVID-19 pandemic was a special circumstance, but the slowdown period lasted just a few weeks before the cycle moved to recession status. In July 2021, the U.S. economy was set up for another expansion as the pandemic began to fade. 

The 2009-2021 expansion is not an exception, either. Expansions just last longer. The closest thing to the most recent bull run was an expansion from March 1991 to March 2001, during which the U.S. economy had 120 months of expansion. It was the longest bull run up until the 2009-2021 bull run broke that record. And, in both cases, it’s very clear which segment of the business cycle dominated the timeline.

Why would someone invest based on the stages?

Why do trends exist? Well, because some things tend to happen in repeat fashion. While that can always change, our understanding and analysis of market conditions show that certain individual sectors perform better at different times. Why? Well, because as we just explained — they just do. 

This is why many investors buy the entire market through ETFs such as $ITOT. However, active investors can use the business cycle and an understanding of sectors and industries to generate greater returns. They can pursue those returns at a broad level, by purchasing sector ETFs and reweighting them based on their observations of the markets, or at a granular level by purchasing individual stocks. 

It’s important to remember that the business cycle is not concrete; it’s not necessarily a beat-all-end-all to guarantee trading success. However, an understanding of how sectors trade given market conditions will help investors make more informed decisions.

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