How Business Cycle Works with Value Investing

Business Cycle

The performance of sectors in the equity market is affected by cyclical factors of the economy. Understanding the patterns of sector performance can help us more effectively manage asset allocation and maximize return of investment at different phases of business cycle.

Business cycle approach is a medium – long investment approach, which could range from several months to multiple years. Each business cycle consists of four phases: early cycle, mid-cycle, late cycle, and recession.

Early Cycle Phase

Early cycle phase of a business cycle features sharp recovery from the previous recession in major economic indicators such as growth in GDP and industrial production, and low corporate inventory levels. Despite strong growth and return, based on the historical data, this phase is often the shortest among the four phases, approximately lasting for one year.

The equity sectors that tend to have strongest performance during the early cycle phase are those that are more sensitive to signals of economic improvement and benefit from lowering interest rate and expansionary monetary policy, such as consumer discretionary sector, financial sector, and real estate sector. They are followed by industrials, information technology, and materials sectors as rapid economic recovery during the early phase cycle raises the hope for more corporate spending. In comparison, healthcare, energy, communication, and utility sectors often underperform.

Mid Cycle Phase

Mid cycle phase usually is the longest phase in a business cycle and features positive but moderate growth of the economy. During this phase, information technology sector (e.g. semiconductor and hardware industries) tends to perform the best as companies start increasing capital expenditure after rapid growth in the early cycle phase. Similarly, communication sector (e.g. media industry) is also likely to outperform. Material and utility sectors, however, tend to underperform.

It should be noted that most market corrections take place during this phase. As a result, the differences in performance among sectors are the smallest comparing to other phases.

Late Cycle Phase

Late cycle phase features slowing growth, overheating economy, rising inflationary pressure, and tightening labor market. During this phase, energy and materials sectors tend to perform well thanks to the inflationary pressure built up in the previous cycles. Additionally, due to the sluggish growth, investors turn to more defensive allocation of assets, which boosts the performance of healthcare, consumer staples, and utilities sectors and undermines that of information technology and consumer discretionary sectors.

Recession Cycle Phase

Recession cycle phase, as the name suggests, features significant negative growth, scarce credit, and low corporate inventories and sales. Consumer staples, utilities, and healthcare sectors perform relatively well comparing to other sectors because the consumption of these services is unlikely to be significantly affected by recession.

Summary

Every business cycle is different. However, some sectors have shown consistent patterns of outperformance or underperformance throughout previous business cycles. The following table summarizes the sector patterns. The most recent comparisons of sector performances and Undervalued Index Reports for each sector/industry/subindustry can be found here. Hope these tools will help you identify not only the promising sectors but also the most undervalued stocks in those sectors!

SectorsEarlyMidLateRecession
FinancialsStrong   
Real EstateVery Strong  Very Weak
Consumer DiscretionaryVery StrongWeakVery Weak 
Information TechnologyStrongStrongVery WeakVery Weak
Industrials  Very Strong  Very Weak
Materials  StrongVery WeakVery Strong 
Consumer Staples  Very StrongVery Strong
HealthcareVery Weak Very StrongVery Strong
EnergyVery Weak Very Strong 
Communication Services Strong Weak
UtilitiesVery WeakWeakStrongVery Strong
Patterns of Sector Performance in Business Cycle

Caveat

The outperformance of a sector does not necessarily mean all industries within the sector follow the same trend. It is possible to for some industries or subindustries in a sector to outperform while others don’t.

4 thoughts on “How Business Cycle Works with Value Investing”

    • Hi Chelsea,

      Thank you for your good question. The US economy is at the late phase of a recession stage. So, in the near future (most likely after vaccines to the COVID-19 is available), consumer discretionary, industrial, and real estate would be the three sectors that you could see strong rebound.

Comments are closed.