InvestorQ : I want to understand what business cycle is and how do business cycles impact my investment strategy? Is there something called business cycle investing that I can do?
Rutuja Nigam made post

I want to understand what business cycle is and how do business cycles impact my investment strategy? Is there something called business cycle investing that I can do?

Arti Chavan answered.
3 years ago

The business cycle, which reflects the fluctuations of activity in an economy, can be a critical determinant of equity sector performance over the intermediate term. A typical business cycle features a period of economic growth, followed by a period of slowing growth, and then a contraction, or recession. The cycle then repeats itself. As the cycle word suggests it is a circular phenomenon and smart equity investing can be done by identifying the length and depth of the cycle well in advance and positioning your trades accordingly.

Every business cycle is different in its own way, but certain patterns have tended to repeat themselves over time. Fluctuations in the business cycle are essentially distinct changes in the rate of growth in economic activity. This includes 3 key cycles—the corporate profit cycle, the credit cycle, and the inventory cycle—as well as changes in the employment situation and monetary policy. While unforeseen macroeconomic events or shocks can sometimes disrupt a trend, changes in these key indicators have historically provided a relatively reliable guide to recognizing the different phases of an economic cycle.

There are 4 distinct phases of a typical business cycle:

Early-cycle phase: Generally, a sharp recovery from recession, marked by an inflection from negative to positive growth in economic activity (e.g., gross domestic product, industrial production), then an accelerating growth rate. Credit conditions stop tightening amid easy monetary policy, creating a healthy environment for rapid profit margin expansion and profit growth. Business inventories are low, while sales growth improves significantly.

Mid-cycle phase: Typically the longest phase of the business cycle, the mid-cycle is characterized by a positive but more moderate rate of growth than that experienced during the early-cycle phase. Economic activity gathers momentum, credit growth becomes strong, and profitability is healthy against an accommodative—though increasingly neutral—monetary policy backdrop. Inventories and sales grow, reaching equilibrium relative to each other.

Late-cycle phase: This phase is emblematic of an "overheated" economy poised to slip into recession and hindered by above-trend rates of inflation. Economic growth rates slow to "stall speed" against a backdrop of restrictive monetary policy, tightening credit availability, and deteriorating corporate profit margins. Inventories tend to build unexpectedly as sales growth declines.

Recession phase: Features a contraction in economic activity. Corporate profits decline and credit is scarce for all economic factors. Monetary policy becomes more accommodative and inventories gradually fall despite low sales levels, setting up for the next recovery.

The performance of economically sensitive assets such as stocks tends to be the strongest during the early phase of the business cycle when growth is rising at an accelerating rate, then moderates through the other phases until returns generally decline during a recession. In contrast, more defensive assets such as Treasury bonds typically experience the opposite pattern, enjoying their highest returns relative to stocks during a recession and their worst performance during the early-cycle phase.

The US economy experienced 11 business cycles between 1945 and 2009, with the average length of a cycle lasting little less than 6 years. The average expansion during this period has lasted 58.4 months while the average contraction has lasted only 11.1 months.

Some investors seek to profit from changes in the business cycle by using what is called a "sector rotation strategy." A sector rotation strategy entails "rotating" in and out of sectors as time progresses and the economy moves through the different phases of the business cycle.

The strategy calls for increasing allocations to sectors that are expected to prosper during each phase of the business cycle while under allocating to sectors or industries that are expected to underperform. The goal of this strategy is to construct a portfolio that will produce investment returns superior to that of the overall market.

Currently, the Global Industry Classification Standard (GICS®) structure includes 11 sectors: consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, real estate, communication services, and utilities. Prior to 2016, real estate was included within the financials sector, but now it is classified as its own unique sector.

Business cycles and sector rotation strategy

In equity investing you must have heard of sector rotation strategy. A sector rotation strategy basically refers to shifting out of sectors that are in the last phase of the business cycle and getting into sectors which are in the beginning of the growth phase of the business cycle. Remember that such a business cycle approach can also be adopted at a company specific level and not just at a sectoral level.

One underlying premise of sector rotation strategies is that the investment returns of stocks from companies within the same industry tend to move in similar patterns. That's because the prices of stocks within the same industry are often affected by similar fundamental and economic factors. This is a product of the sector classification framework itself: Companies are grouped together based on their business models and operations, which ensure companies within a sector have similar economic exposure and sensitivities.

For example, in the early 2000s, rapid development of new technologies fuelled growth within the information technology industry, and most stocks in that sector trended higher. Alternatively, most stocks in the financial sector moved sharply lower during the collapse of the subprime mortgage market and the subsequent credit crisis in 2008–2009. The decline of stocks in the financial sector during the financial crisis once again demonstrated how stocks in the same sector often exhibit similar performance during a particular phase of the business cycle.