Understanding Business Cycles and Their Impact on Stock Performance

As a big believer in sector rotation and finding leadership in a market, I closely watch which sectors are performing better. This is beneficial in two ways. First, by over-weighting your mix into leadership sectors, you may add alpha to a portfolio, where alpha is defined as risk-adjusted value over a benchmark or index. Second, it can give signs on where we currently are in the overall stock market cycle.

To know how to use this information found in sector rotation and leadership we need to review the stock market stages and which sectors have, historically, performed better in each.

Stage 1:  The early stage of a new bull market rally

This stage typically has the largest gains in a bull market cycle. Usually the Federal Reserve will lower rates in a recession to spur the economy back on the right track. It makes sense then that interest rate sensitive stocks would perform best when coming out of that environment. These include financials, consumer discretion, and industrials. At the later end of this cycle, technology sector heats up.

Stage 2:  The recovery stage

This stage is when the economy grows more moderately but for a longer period of time. Stage one typically lasts 12 -18 months while stage two can last 30-48 months. Sector leadership comes from inflationary sensitive industries such as energy and materials. The service industry also does well since in the early stages of recoveries it is more about production. Technology continues its surge from the later phase of stage 1. Really, in the midst of this phase, most sectors are doing well with the exception of some defensive areas like utilities.

Stage 3:  The euphoria stage

Everything is great, people start predicting the market will double or even triple from here, and investors ignore the signs of the economy. Historically, the yield curve is flattening, consumer sentiment starts to flatten or decline, and industrial production is no longer increasing.  In the latter phase of this stage we enter the early recession period also. Historically, in the early part of the stage, materials and energy do well but that changes to utilities, consumer staples, and healthcare during the latter part due to investors getting defensive while preparing for a recession. Recall, the markets are a 6-9 month forward looking mechanism.

Why do I write this today? Per Morningstar, the three leading sectors so far in 2014 are basic materials, utilities and healthcare. To be clear, there may be other reasons those sectors are doing better such as investors searching for yield due to bond rates, the Affordable Health Care Act and a continued rebound to material which suffered for the most part in 2013.

With that said, we at Virtus Wealth Management have made changes to our leadership mix in our portfolios.   Not necessarily to the sectors mentioned above, but we are definitely seeing a change in leadership.