We show you how to win on business cycles

There are many components to a successful stock market investment, but one of the fundamental ones is to understand what is happening in the economy and how it affects company profits and valuations. For this, you need to know three things:

1. how the yield curve behaves,
2. where we are in the business cycle
3. how the profit prospects develop.

And in this article, we’ll show you how we can determine where we are in the business cycle and in a given part of it, which are the sectors that can perform better. Of course, it is important to emphasize at the outset that there may be external events and industry effects (e.g. government intervention, coronavirus) that may even permanently deviate the behavior of a sector from the way it should behave based on the business cycle.

However, in general, in the majority of cases, this approach works quite well and provides a background for exactly where to look for those sectors, individual stock investments, in which you can have fantasy in the coming months, or even years.

What are business cycles?

Let’s start right away with the official definition. The business cycle (or business cycle) is a fluctuation in the performance of economies, where economic activity expands and decreases one after the other. Within this, the length of each section may vary from cycle to cycle. According to the narrower interpretation, the business cycle can be described by the development of GDP, but according to the broader interpretation, the indicators describing the economy must be together point in one direction in order to determine the direction of the cycle. For example, in addition to GDP, retail sales, unemployment, industrial production and other indicators.

Four stages can be distinguished within the economic cycle:

1. Recession: The growth of variables describing the economy is negative, borrowing opportunities are scarce, profit rates are deteriorating rapidly, and may even become negative in some sectors. Meanwhile, monetary policy is beginning to ease to offset the economic slowdown. Despite weak demand, inventories are falling even faster as the corporate sector is pessimistic about the future.
2. Recovery: In this stage, the growth rate of the variables describing the economy turns from negative to positive, and then growth begins to accelerate. Lending conditions are no longer tightening thanks to the loose monetary policy. As a result, corporate investments begin to pick up, and profit rates begin to rise. At that time, stocks are still low, but demand is already picking up.
3. Expansion: This is usually the longest part of the cycle. Growth is moderately high, but lower than during the accelerated phase of recovery. Lending is strong, profit prospects are favorable, monetary policy is still slightly supportive at the beginning of the expansion, and then transitions to neutral. Inventory growth is catching up with demand.
4. Deceleration: The economy becomes overheated, inflation rises, monetary policy begins to tighten, lending conditions tighten. Due to higher interest rates and deteriorating growth prospects, consumers will be more cautious, profit prospects will deteriorate, and the economy will begin to slow down. Inventory growth outpaces demand.

It is important to note that the above listing shows a typical cycle. However, external shocks such as a health emergency, oil price shock, a new economic policy program, or other external shocks can significantly influence this. However, historical experience shows that their effect is only temporary and in the long term the American economy moves quite well in this area. This is true even if more has happened between 2020 and 2024 than at any other time in 20 years.

The chart below shows that since the 1870s, the number of months spent in recession has been steadily decreasing. This is because central banks and economic policy makers are increasingly familiar with the processes that usually lead to recessions. (This could be the case, for example, of a banking crisis, exchange rate crisis, real estate or stock market bubble formation and bursting.) Therefore, they can intervene in economic processes sooner and more efficiently. Another reason for the shortening of recession periods is that the structure of the American economy has changed a lot in 150 years. While in the past the manufacturing industry dominated (which is much more cyclical), today the service sector accounts for 70% of the economy. One of the consequences of this is that the American economy falls into recession less often, but when it does, it can only be pulled out of it with very serious state aid.

So far, all is well and good, but how will this become an investment?

It is clear from the above that economic cycles can be divided into four well-defined stages. In these, monetary policy behaves differently, sales and profit expectations are different, as well as the companies’ inventory strategy and lending conditions.

Consequently, the idea that different sectors can perform well in different stages of economic cycles is not from the devil. This is supported by the fact that the main sectors of the economy have different characteristics, sales revenue structure, profitability, growth prospects, debt situation and customer base.

Below is a summary table showing which sectors may underperform or outperform in certain stages of the business cycle.

1. Recession: In this phase, consumer staples, healthcare and utilities companies may outperform the S&P 500 index. As we wrote earlier, at this stage of the economic cycle, monetary policy is loose and growth prospects are poor. The above three sectors basically pay high dividends and have a low but, in return, predictable and secure growth trajectory. Therefore, their sales are relatively resistant to the slowdown of the economy, while they can also benefit from the decrease in interest rates through the valuation effect.
2. Recovery: When the economy is in a post-recession recovery phase, the consumer discretionary, materials and real estate (REIT) sectors perform best. In this phase, interest rates are still low, but growth and profit prospects are already improving. Companies have low inventories, so profit margins can expand quickly as demand picks up.
3. Expansion: In this phase, finance, IT and telecommunication services perform well. During the expansion phase, economic growth is no longer outstanding, and interest rates begin to normalize. In this phase, finance is performing well because overall growth is still supportive and the sector’s profit prospects are also improving due to the rise in interest rates. IT and telecommunications services perform well because the corporate sector is highly optimistic, their profit prospects are favorable, and their debt levels are decreasing. In this phase, they are more willing to spend on investments that improve productivity.
4. Deceleration: At this stage, due to the slowdown of the economy, the outlook is more uncertain, and consumers spend more cautiously. In such cases, sectors that are relatively insensitive to changes in economic growth perform better. And this is daily consumer goods, healthcare. At times, industry also outperforms, but only because the capacity expansion investments of the corporate sector are usually started at the top of the cycle, and for industry this means a positive tailwind for a while, even in the period of slowdown.

Based on the above, you can already see what the process will look like. Based on the development of macroeconomic variables, market expectations and central bank communication, we place where we are in the economic cycle, which determines which sectors have the potential to outperform.

I’ve read it so far, I understand everything, but what should I buy now?

Currently, the American economy may be on the border between expansion and slowdown phases. This is supported by the deteriorating consumer confidence indices, the ISM purchasing manager indices, the slowing retail turnover and the weakly performing industry.

Based on the table, it can be seen that in the expansion phase, finance, IT and communication services perform well, while in the slowdown phase, daily consumer goods, healthcare and industry perform

In recent months, IT and communication services have driven the market, as it should have been according to the framework of the model. The financial sector has joined the camp of outperformers in recent weeks. Industry also performs better compared to the index, but consumer goods and healthcare are still underperforming.

However, an interesting reverse thought experiment can be made from this. If we are really clearly in a slowdown phase, why are the latter two not outperforming? One possibility is that we are seeing market mispricing (low probability) and the other possibility is that the market consensus is that we are not yet in a slowdown phase, but at the end of an expansion phase or at the very beginning of a slowdown phase. The latter is supported by the fact that the expansion of American employment is expanding nicely and the unemployment rate is just over 4%.

Based on the above, as long as employment holds up, there may still be potential in the finance and industry sectors. And after a consolidation phase, the IT sector can also rejoin the camp of outperformers. On the other hand, when daily consumer goods, health care, and, God forbid, public utilities outperform, the market can enter a truly vulnerable phase.

If I want to use it later, what should I pay attention to?

The first and most important note is that – just like the others – this approach usually works, but not always, so you shouldn’t take his claims as scripture, but think about the messages sufficiently critically.

And the second important thing is that, for example, during the period of expansion, technology and finance are the outperformers. However, this does not mean that there cannot be weeks or even months when the above two sectors underperform. However, if we are reasonably confident that we are in an expansion period and we see prolonged underperformance in the above two sectors, then it is usually a high-probability entry opportunity.

Finally, it is also worth bearing in mind that not only the economy can give an idea of ​​which sector may be the best, but also the behavior of the sectors can carry a valuable message in terms of the economic outlook. That’s why it’s worth looking at the two back and forth. This kind of thinking can help us remain more open to new information and react to it more quickly. Usually, the latter is one of the qualities that separates beginners from pros in the stock market.

The cover image is an illustration. Cover image source: Getty Images

This article does not constitute investment advice or investment recommendation. Detailed legal information