WASHINGTON. Today’s column marks another slightly out-of-sequence installment of our periodic Investing 101 series. In this edition, we take a look at two important elements in our ever-changing economy that strongly influence where investors put their money at any given time. Namely, business cycles and sector rotation.
Capitalism: Birth, death and renewal
Alexandria Ocasio-Cortez aside, America, at least up to this point, has generally pursued the business of business far more successfully than most countries around the globe. We can attritute this in large part to the robust, moderately controlled form of capitalism we developed right here over the course of nearly two-and-one-half centuries .
At its most successful, American-style capitalism has led to growth, jobs and prosperity. At its worst, it has allowed too few individuals to amass too much wealth at the risk of unbalancing the system. But in the end, our economy has generally rebalanced itself after cyclical downturns, with an occasional application of discipline (or economic trickery) by the Federal government.
From the time capitalism emerged in the West, the key to a successful capitalist system has always been the vigorous competition that businesses need to survive and prosper. At its best, our economy is a competitive sport with business winners and losers. Those in the latter category must either right size their operations and rebound. Or fiddle around and fail, or get bought out by the competition. At the risk of sounding simplistic, we would observe that in many ways, this competitive business cycle is a lot like the human life cycle: conception, birth, growth, maturity and death. Or rebirth. It depends. But that’s another topic.
The capitalistic US economic engine follows the same general business cycle we just noted. Aka, the economic cycle, or business cycle. After an economic slowdown – which can turn into a recession or a depression – businesses scramble to do what’s necessary to survive while plotting what they’ll need to do in the next business cycle to get back on track. And that’s what they’ll do as the economy selectively picks up. Their collective effort usually gets the economy back up to ramming speed fairly quickly. That, in turn, leads to another cyclical period of prosperity.
Once the economy inevitably overheats, leading undesirable inflation to rear its ugly head. At this point, something goes wrong or gets out of control. That’s when, in our current era at least, the Federal Reserve generally puts on the brakes and the economy slows. But if that intervention isn’t carefully done, if the Fed stomps on the brakes too hard, the economy gets crushed and we get a recession. At which point we start all over again.
Economists use fancier terms to describe this cyclical activity: early expansion, maturing expansion, late expansion, and recession. But the birth, death and renewal pattern remains pretty much the same. That’s important for an investor to know.
Notable exceptions to normal business cycles
True, what happened to the economy in 1929 and again in 2008 was a bit different. In both cases, parts of the economy became completely overheated due to business and investor overconfidence and an abuse of leverage (borrowed money). That’s an important part of what former Fed Chair Alan Greenspan colorfully termed “irrational exuberance.” At times like these, such unwarranted exuberance, built on a house of borrowed cards, collapsed suddenly and completely. The result was economic chaos and nearly universal hardship.
Today, Wall Street investment advisors categorize the vast array of publicly traded businesses into business sectors. Business sectors are classes of similar or related businesses that perform roughly the same function in our economy. Retail sales is one such category or business sector. To oversimplify a bit, the retail sector, officially known as the “Consumer Discretionary” sector, largely consists of the stores where we shop. Examples: department stores, dollar stores, discount warehouse stores, etc.
Over time, S&P created a list of 10 (now 11) of these business sectors into which it places other categories of “like minded” stocks.
But rather than discuss each sector by name and specialty, let’s consider why knowing about these business sectors is important to all investors. It has a great deal to do with business cycles.
As a moribund economy begins to pick up in the business cycles, some sectors wake up early in the game. Later, as the economy heats up and peaks, other sectors begin to reignite in a relatively predictable sequence. At the same time, the earlier sectors begin to fade and flatten out, profit and performance wise.
At the end of a business cycle, when the economy hits its peak and bust phase, “safe” business sectors, like the “Utilities” (electric companies, natural gas, alternative energy, water) are where investors go to hide. After all, everyone has to buy energy whether they like it or not.
So what does this mean for investors? It generally means that you try to time your new investments in the latest rising business sector(s) to coincide with the next likely up and coming sector(s). That’s known as investment timing. And, as each sector peaks, investors try to sell those investments profitably. As they do so, they move to invest in the next rising sector. They’re trying to take advantage of the sector rotation pattern that occurs during each business cycle.
What does this mean for you?
As an investor, you don’t have to follow sector rotation religiously. That’s particularly true if you have long-term holdings that generally ride out economic storms over time. But you must still be aware of sector rotation. As each succeeding sector rises and peaks, the movement of stocks within it can cause great near-term success – or severe damage – to your portfolio. Timing your entrance and exits is important in order to avoid such pitfalls. That certainly held true last fall during the nasty, sudden downturn concluding the fourth quarter (Q4) of 2018.
NEXT: What to do when Mr. Market is indecisive and the direction of the business cycle and sector rotation is hard to see.
— Headline image: Man, woman, birth, death, infinity. Screen shot, via YouTube video,
of opening blackboard splash screen from “Ben Casey” TV series. (1961-1966)