Business Cycling: The Role of Economic Cycles in Sector Investing

High tide and ebb tide. Full moon and new moon. Bull market and bear market.

The world seems to move in cycles. Some are as predictable as the Old Faithful geyser, while others are inevitable but somewhat random in their timing and length.

Economic cycles fall into the latter category. And although economic pullbacks aren’t always easy to identify, some elements are. The basic economic cycle consists of four phases: expansion, peak, recession, and recovery. Each phase tends to favor different segments of the economy.   

Taking a Step Back: Sectors Explained

When you think about growth investing, you might picture new technologies and companies that use them, such as social media, biotech, and the so-called “sharing economy.” Growth is fun. Growth is exciting, especially in boom times. 

But times aren’t always booming. 

What about strategies for capital preservation and income? Sounds like that healthy breakfast cereal your parents wanted you to eat. The benefits seemed intangible in the short term, and whole grains seemed dull compared to the sugar-high-inducing stuff. But depending on which phase of the economic cycle we’re in, the action might move away from the high-growth sectors. 

Sector-based investing and economic cycles go hand in hand, letting you rotate in and out of different sectors depending on the economic cycle. The stock market tends to reflect where the economy is in those phases, and certain sectors tend to perform better during certain phases. The graphic below lays out the four phases and the sectors that are typically targeted by sector investing.

Targeted investing in stock sectors can be one potential 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, bonds, and other fixed-income securities. 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.

Capital Appreciation from Growth; 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 your investing objectives.

When growth is the order of the day—that is, during the expansion and peak phases—Technology, Communications Services, and Consumer Discretionary sectors tend to perform well as consumers gravitate toward “more stuff.” As the economy reaches its peak, the Materials and Energy that fuel the expansion may kick into high gear.  

During recession and recovery, it’s about playing defense and perhaps targeting income from dividends. Some sectors, such as Utilities, Consumer Staples, and Real Estate may provide dividend income, allowing an investor to potentially earn income in their portfolio through dividend issuance. These dividends may be used to purchase more shares, or may be taken as income. 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. That’s part of what makes a dividend strategy stable but risky at the same time.

Risks of Sector Investing

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

Following a sector strategy can also mean paying more in transaction costs, as investors may make more adjustments to their portfolios.

And then there’s the timing issue. If you’re looking to benefit from cycle changes, you should start preparing for the next phase of the cycle when you recognize the phase you’re in. But that can be a double-edged sword, because it’s so hard to time when these phases begin and end. Even top money managers have a hard time hitting it right, so timing can be especially challenging for the retail investor. 

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 (see figure 1). The tool 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 it, log on to tdameritrade.com and go to Research & Ideas > Markets > Sectors & Industries. 

Once you’ve identified sectors to target, you might consider finding investments that meet your objectives. Looking for individual stocks within a sector? Select a sector and scroll down to see subsectors, industries, and some of the companies that drive the sectors. From there, you can check analyst ratings and company fundamentals. Alternatively, you could set up a screener to help narrow the search. 

You can screen for stocks, exchange-traded funds (ETFs), and mutual funds, and you can filter by sector, industry, and sub-industry. From there, you can set up a host of filters, such as fundamentals, dividend history, technical indicators, and more.

The Bottom Line on Cycles and Sectors

Expansion, peak, recession, recovery, repeat. It’s the nature of the economy. As with the ebb and flow of the tide, you can wait it out, or you can grab a surfboard and go for a ride.  

A sector-based plan is a nontraditional alternative to buy-and-hold investing. Or it can be an adjunct strategy. You don’t need to be all in or all out. Consider allocating a portion of your portfolio to sector-based investing, and keep the rest of it in more traditional investment strategies.