Business Cycle Investing

The economy changes over time.  Industries which perform really well under certain conditions may shrink or disappear entirely under others.  Some of this is due to changing technology and consumer preferences; computers used to be women who did complicated mathematical calculations by hand (including those that got John Glenn into space), and the English language is replete with last names that originated as professions in obsolete or much-shrunken industries (Mercer, Cooper, Faulkner, Cartwright, Collier, and Kellogg being just a handful of the less obvious ones).  But many of the medium-term fluctuations in industrial performance can be attributed to the business cycle, or the regular expansion and contraction of the economy.

What is the Business Cycle?

The business cycle is often depicted as a curved line on a graph, indicating expansion (a bull market) or contraction (a bear market) of the economy over time.  All of the activity from one period of expansion to the next is considered to be a full business cycle.  For investment purposes, economists generally talk about four stages of the business cycle:

  1. Early-cycle: just after the market reaches a trough (bottom), the economy begins to grow due to both business and consumer spending.
  2. Mid-cycle: the economy continues to grow, typically surpassing values that were seen at the last peak (top).  Spending continues, but at a more moderate pace.
  3. Late-cycle: growth begins to stall as credit becomes tighter, and consumers start to spend less, until the cycle reaches its peak.
  4. Recession: growth contracts as both businesses and consumers scale back on spending
An typical illustration of the business cycle, with expansion and contraction marked by troughs and peaks.

An typical illustration of the business cycle, with expansion and contraction marked by troughs and peaks.

Determining the Stage of the Business Cycle

One of the biggest challenges to using the business cycle for investing is knowing what phase you are in, and gauging how much longer it may last.  Neither business cycles nor their phases are of equal, predictable length.  On average since 1926, periods of growth will last for 9 years, while periods of contraction will last for 1.4 years.  But this alone is not a good predictive tool, because growth has historically lasted as long as 15.1 years, or as short as 2.5 years, while recessions can be as short as 3 months, or last as long as 2.8 years.  Length of time since the last trough is simply not good enough for predicting when the next peak will occur.  Added to this, some economists disagree as to how economic expansion should be measured.  While most will count the start of a bull market as being the low-point of the previous trough, others will declare a bull market only after the market has recovered to the point of the previous peak.  The problem with this method is that some periods of expansion have seen considerable growth without ever matching the previous peak before reverting to recession, as happened in the early 1970s; it is impossible to tell where the economy is in a new business cycle simply by comparing prices to where they were during the previous business cycle.

Instead of relying on time or prices, investment analysts will use indicators to determine where we are in a business cycle.  These include leading indicators like factory orders and housing permits, which often predict a change in the business cycle before it occurs, as well as lagging indicators like manufacturing output and the consumer price index, which can help analysts to confirm that a change has occurred and was not simply a sampling error.  Some indicators are also coincident like unemployment rates or income levels, and can confirm that a change is ongoing as it occurs.  No one indicator is enough to determine the current stage of the business cycle.

How to Use the Business Cycle for Investing

Analysis of the business cycle can not only help investors decide where to invest, but also better prepare their portfolios for coming changes.  At certain stages of the cycle, certain investments tend to outperform, while others will underperform.  For example, technology and financials tend to outperform in early-cycle stages, as the cost of borrowing as low.  In mid-cycle, industrials pick up as consumers have more discretionary money to spend.  Towards the end of a cycle, as markets begin to get jittery, energy and materials tend to be better investments, as investors flock to them in search of greater stability.  During a recession,  essential goods and services like health care and consumer staples tend to perform best, because they are areas in which consumers can't simply choose to cut back on their spending.