The rise and fall of the economy in America and elsewhere can generally be classified into a cyclical pattern that repeats itself over and over. Although their timing can be hard to predict, those who are able to recognize them when they occur can use this to their financial advantage in many cases. Learn the characteristics of each major phase of the cycle and the possible ramifications that they may have on your investment portfolio.
The 4 Basic Phases
A complete economic cycle can be broken down into four subcategories: expansion, peak, contraction and trough. The U.S. economy typically goes through an entire cycle in a period raging from six months to about 5 years. The length of each phase of the cycle will vary according to current economic conditions and the overall length of the cycle.
The expansion phase begins when the economy finally begins to recover from a recession. During this phase, the Fed will usually start to ease its monetary policy and thus allow credit to become more available. This injects money and liquidity into the economy, which stimulates further growth and boosts the earnings of corporations. As the economy solidifies, consumer discretionary income increases and leads to greater spending. The stock market begins rising and economic numbers improve.
After a period of expansion, growth finally starts to taper off and corporate earnings reach their peak. Consumer spending continues and interest rates bottom out. Stock prices level off and often begin to retrace the most recent segment of their growth. This phase of the cycle usually lasts longer than any other.
Economic growth eventually starts to slow and inflation begins to spiral upward. Consumer pessimism asserts itself. Economic numbers start to wane and unemployment rises.
This is the period of recession where the economy bottoms out. The money supply has virtually dried up and the Fed is raising interest rates in order to curb inflation. The markets are hitting a low as company profits recede and consumer spending has slowed to a trickle. This phase will of course eventually give way to a new period of growth that starts the cycle over again.
How to Profit from Economic Cycles
Although investors who are able to ride out the rise and fall of economic cycles over long periods of time can still reap substantial returns, those who adjust their portfolios and strategies for each segment of the cycle can achieve superior returns over shorter periods in many cases. For example, the entertainment industry typically sees a spike in business during recessions, because the demand for something that allows consumers to be able to forget about their financial woes for even a short time becomes very strong during this period. The stock market is generally viewed as a leading indicator of the economy, as both its growth as well as its decline has historically preceded that of the economy. This is primarily because the markets tend to look forward, so to speak, as their performance depends heavily upon future projections while economists compute their numbers based upon recent historical data. Therefore one way that you could apply this knowledge would be to see how a recession can lead to lower interest rates, because lowering rates is the traditional tool that the Fed uses to stimulate economic growth. And when interest rates fall, bond prices rise, which means that it may be a good time to buy them. Then, when the economy reaches its next peak, you can sell those bonds at a profit, because they will begin to fall again in price because rates are now low. Another idea is to get into consumer cyclicals and financial stocks during early periods of growth, because these stocks are especially sensitive to interest rates and will often rise in value faster than the market as a whole.
One of the ways that economists determine where we are in the economic cycle is by watching various economic indicators, such as Gross Domestic Product, interest rates, inflation, employment numbers and productivity. Rising inflation indicates economic growth while falling GDP and employment figures reflect periods of contraction.
Time the Market with Sector Funds
Although market timing is an inexact science fraught with peril and uncertainty, those who decide to attempt this can improve their odds by watching the economic cycles and moving their money to the appropriate sectors during the various stages of the cycle. As mentioned previously, consumer cyclicals, transportation and technology stocks can be good picks during a recession, as they tend to flourish when the economy starts to recover. Then, when the economic recovery shifts into high gear, other sectors often experience periods of strong growth, such as precious metals, healthcare, energy and capital goods. Commodities also typically peak when the economy starts to cool off again.
If you are going to try a strategy that requires market timing, you should probably look to ETFs that invest in each of these sectors in order to maximize your liquidity and minimize trading costs. Also remember that there will not necessarily be a unanimous consensus on exactly when we enter or leave a particular phase in the cycle, and you will ultimately have to decide for yourself when to shift your portfolio from one sector to another.
The Bottom Line
Economies have moved in the cycle described above since the dawn of civilization. Investor who understand how these cycles work can profit from them over time by continuously shifting their money into the sectors that are profiting from the current phase of the cycle. ETFs such as the ones offered by Blackrock Capital now make it easy to invest directly in any sector or subsector of the market. For more information on economic cycles and how you can profit from them, visit Blackrock Capital’s ETF website at www.ishares.com or consult your financial advisor.