Uncategorized, Weekly Update

Business Cycle/Sector Investing Takes a Curve Ball This Cycle

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Published August 23, 2019


Business cycle/sector investing is a seemingly easy way to apply a layer of insight to traditional buy-and-hold investing. By focusing our investment funds on sectors that typically show improved performance during certain phases of the business cycle, a sector investor can presume to outperform the broad market. However, it is never quite that easy. Below is a good overview from Brad Sorensen of business cycle/sector investing and the disconnects and divergences that have shown up in the current cycle.

“It’s different this time”.

That phrase can be one of the most dangerous mindsets for investors to have—every business cycle has differences, of course, but ignoring historical evidence can be dangerous. We heard that phrase bandied about during the tech bubble in the late 1990s, only to find out it really wasn’t all that different—having a profitable business still mattered! I have the opposite phrase running through my head on a loop—“it’s never different”—to remind myself not to ignore history when looking at the potential future.

However, lately there have been developments that have led investors to consider that things might actually be different—at least somewhat.

Before we get into that, let’s do a quick review. The business cycle is a term that describes the rise and fall of economic activity. The business cycle usually follows a predictable path, beginning with early expansion, which is usually marked by rising growth as the economy emerges from a downturn. As the tide rises toward maturing expansion, employers start to hire more, consumers earn and spend more, companies build more…and inflation starts to increase. In late expansion, inflation becomes concerning, imbalances build up, the Federal Reserve starts to tighten policy and growth peaks and starts to descend in recession—eventually to start the cycle over again.

What has made the business cycle particularly helpful for investors is that certain areas of the economy have tended to outperform or underperform depending on the stage of the cycle. Those favored sectors are summarized in the chart below. As a reminder, these sectors will not perform this way every time, but they have generally exhibited this correlation to the specific phase of the cycle.

The four phases of the business cycle

Finance students throughout history have relied on something similar to the above table when learning about the relationship between the stock market and the economy. The challenge has been determining where we are in the business cycle, and if there are any anomalies that would render the above guidelines inaccurate this time around.

Has something changed this time? Is this time possibly different?

Possibly. For example, the real estate sector and the utilities sector are both up by more than 13% over the past 12 months, while communication services and consumer staples have been the third- and fourth-best performers over the past year. Utilities and Consumer Staples usually hold up best in a recession. Yet, we have not seen evidence that we, domestically at least, are in a recession. So, we have to at least wonder if something is different in this cycle.

For one thing, inflation has failed to materialize so far this cycle. This has removed a major driver of rising late-cycle interest rates. The Late Expansion phase above usually sees strong performance from energy and materials, both groups that drive and benefit from rising inflation.

Additionally, coming out of the 2008 financial crisis, we had unprecedented actions by central banks that are continuing to this day. Central banks have pushed interest rates below zero in some countries, with German 10-year bonds recently trading at yields of -0.60%, while Japanese 10-year yields were recently below -0.20%. That means that investors are willing to loan their money to governments—and get less money back in return! That is indeed different—and certainly not covered in any of the finance/investing textbooks! As a result of this and many other factors, U.S. rates have stayed remarkably low for an extended period.

10-Year Treasury yield

What’s the result? We’ve seen income-seeking investors looking more to the equity markets for yield; driving thick-yielding sectors, such as real estate and utilities, higher at the same time—historically, real estate would benefit from a good economic environment and utilities would benefit from the opposite. Another change in historical precedent: The financial sector historically has had a negative correlation with interest rates—meaning the sector rose as yields fell—as lower rates stimulated loan demand. However, since the financial crisis the correlation has flipped, with the sector now having a strong positive correlation with rates.

What does it mean?

The first thing is that it means sector investing has become a bit more challenging!
For investors, this doesn’t mean ignoring the economic environment as it will still have a major impact on sector performance. But realize that some of the old relationships may not hold and that investors need to be flexible in their thinking that things, at least for now, have changed. The final lesson is that this environment demands patience. With trade uncertainty and interest rate volatility, sector leadership has shifted from cyclical to defensive quickly multiple times over the past couple of years. Those shifts could well continue until the cycle, very prolonged at this point, reaches its end.

Market Update

Stocks popped higher Monday in response to positive trade remarks from President Trump and Commerce Secretary Wilbur Ross combined with hopes for economic stimulus in other nations. Stocks rose +1.2% on the day. Indexes slipped back -0.8% Tuesday after some confusion over the Trump Administration appeared to back away from a possible payroll tax cut. In positive news on the day, Home Depot (HD) shares rallied on their earnings report. Strong reports from retailers continued Wednesday with Lowes (LOW) and Target (TGT) providing a boost to stocks. The S&P 500 recouped the Tuesday downswing with a +0.8% gain. Minutes from the Federal Reserve’s most recent meeting were received well by markets Wednesday. The minutes were read as being consistent with Chairman Powell’s recent comments and underpinned the market’s view that further interest rate cuts are likely if global economic weakness continues. A report on U.S. manufacturing activity Thursday showed a surprise contraction in activity, the first contraction in almost a decade. This report kept investors in a cautious mood ahead of Friday’s comments by Fed Chair Powell from the central banker’s annual conference. Stock held steady on the day while the 2-10 year U.S. Treasury bond yield spread inverted slightly, as it had the week before. Markets came unglued, however, in Friday’s action with stocks plunging -3% to the bottom of their recent range. The announcement of new trade tariffs by China kicked the day off on a decidedly weak note. Fed Chair Powell’s conference comments appeared to provide support for stocks, with the market quickly overcoming the China news and regaining a positive tilt. But then stocks sold off hard throughout the remainder of the day as President Trump sounded a defiant tone in response to China’s actions. Investor sought safety amidst the uncertainty with interest rates dropping near recent lows.

A fourth consecutive weekly loss for stocks, this time the markets closing at their worst levels of the week. The S&P 500 (SPY) slid -1.38%, finding resistance at its 50-day moving average once again. The Nasdaq 100 (QQQ) lost -1.84%. The small-cap Russell 2000 (IWM) slumped -2.15% and continues to trade at a loss on a year-over-year basis.

Warm wishes and until next week.