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The Role of Market Cycles in Sector Investing

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April 14, 2017
Get the most out of the market with sector investing

When someone suggests strategies for capital preservation and income, it might summon up images of that healthy breakfast cereal your parents wanted you to eat. Sure, it had benefits, but it was kind of dull. 

So it may surprise you to hear that sector investing can be thought of as one tool in a capital preservation and income strategy. Yes, sector investing is often more exciting and inherently riskier than common ways of preserving capital, such as CDs and bonds. But for investors who want a different approach and are willing to accept a bit more risk without getting too aggressive, sector investing may be something to consider, if addressed with care.

Think of sector investing as an investing strategy that can potentially provide income from dividends. Some sectors, such as Utilities, Telecommunications, Consumer Staples, and Real Estate, may provide dividend income, allowing an investor to potentially gain income in their portfolio from dividends. Of course, the payment of dividends is not guaranteed and the issuing and payment of dividends may be discontinued by the company at any time.

Why Use Sector Investing?

One use of sector investing is to attempt to take advantage of market cycles.

“Sector-based investing and economic cycles are tied hand in hand,” Settle said. In this approach, investors rotate into and out of different sectors depending on the economic cycle.”

If other more conservative approaches have not been the right option for you and you have a higher risk tolerance you could consider a more risky strategy that takes into account the dynamics of the business cycle.

Economists often say that a typical market economy cycle has four phases: expansion, peak, recession, and recovery. The stock market tends to reflect where the economy is in those phases, and certain sectors tend to perform better during certain phases. Here’s the standard sector cycle:

Expansion: When the economy is in the expansion phase, Settle said, economic growth expectations are rising. During this part of the cycle, Technology and Consumer discretionary sectors have tended to outperform other sectors because these are the parts of the economy that help fuel economic expansion.

Peak: When the economy reaches a peak, and interest rates start rising, the financial sector often outperforms because bank stocks tend to benefit from rising interest rates. Additionally, Energy and Materials can outperform because the economy tends to generate a lot of growth at these times.

Recession: When a recession hits and stock prices fall, that’s often a good time to consider defensive parts of the market, including Utilities, Consumer Staples and Healthcare, in part because companies in these sectors tend to see steady demand for their products and services even if the economy has peaked.

Recovery: And as the economy recovers, investors might want to look at stocks that often outperform in a recovery phase. These can include Industrials, Real Estate, and Materials. The caveat is that when the market is in a certain part of the cycle, investors may want to consider looking ahead to what sector generally performs best in the next part of the cycle, because the market might get there soon and those sectors might be a better choice.

“Those striving to benefit from cycle changes need to start preparing for the next phase of the cycle when they recognize the phase you’re in, because it’s so hard to time when these phases begin and end, especially for the retail investor,” Settle said.

Income from Dividends

Having a sector strategy as part of a larger, diversified portfolio isn’t just about timing the economic cycle. It’s also about being in the appropriate sector for an individual's investing objectives.

Certain sectors, including Utilities, Healthcare, Telecommunications, and Consumer Staples can potentially provide dividends to investors, with the choice of either reinvesting the dividends to purchase additional shares of stock, or taking them as income.

Risks of Sector Investing

Adjusting one’s portfolio to try to take advantage of sectors takes a bit more effort than just buying and holding stocks for the long term. There’s some risk involved, perhaps more than there would be with a more conservative strategy. The stock market reflects human psychology, which isn’t always linear or mathematical, and that means sector investing can throw the occasional curveball.

For instance, the economic cycle can often give a sense of how sectors might perform, but it isn’t a perfect indicator. We all know that past performance is not a guarantee of future performance. Sometimes, you might end up in a sector that traditionally performs well during a certain part of the economic cycle, but for some reason doesn’t follow the historical pattern and leaves you with losses.

That’s something that wouldn’t happen if you stuck all your money in FDIC-insured CDs paying 1% or 1.5%, because in that scenario you’re guaranteed to get your principal back. The problem with CDs and keeping your money in cash is that you might not be able to keep up with inflation.

Bonds traditionally pay better interest rates than cash, though their growth isn’t historically as strong as stocks. But like CDs, bonds do offer a bit more safety for those who want to protect their capital. Although bonds sometimes lose value—for instance when interest rates rise—they tend to be less volatile than stocks over the long term.

Following a sector strategy also can mean paying more in commissions and fees, because by its nature it requires investors to make more adjustments to their portfolios.

Do Your Research

TD Ameritrade offers a variety of sector-specific research resources designed to help investors understand and implement sector investing strategies. Learn where to start with sector investing by learning about tools such as top-down analysis, Market Monitor, and third-party analyst reports that can help you find investment ideas that align with your specific investing objectives.

The Sectors & Industries tool is one way to perform top-down analysis. This tool (see figure 1) is based on the S&P 500 and its 11 sectors: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services, Real Estate, and Utilities. To access the tool, log in to your account at tdameritrade.com and go to Research &
Ideas > Markets > Sectors & Industries. 

Markets: Sectors & Industries

FIGURE 1: SECTORS & INDUSTRIES SORTED BY 3 MONTH PERFORMANCE.

The Sectors & Industries tool displays the performance of 11 sectors over a specified time period. Image source: tdameritrade.comFor illustrative purposes only. Past performance does not guarantee future results.

A sector-based plan is a non traditional option to potentially consider along with other more traditional investment strategies.

Sift through Sector Candidates

Use Stock Screener to narrow selections based on sectors like technology. Log in to your account at tdameritrade.com > Research & Ideas > Screeners > Stocks.