The idea that economies expand and contract over a period of years, through a process known as the business cycle, has been around for a long time. French economist Clement Juglar was arguably the first to discuss this in detail in 1860, and Joseph Schumpeter later assigned the labels that are most familiar to us - expansion, crisis, recession and recovery.
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Whether the statistical data fully supports the idea or not, the reality is that politicians, business leaders and the media still speak in terms of a recession/recovery/peak/collapse cycle and many investors manage their money accordingly.
While any one company or stock can stand out and perform well in almost any stage of the business cycle, those are the exceptions and not the rule. The rule, by and large, is that stocks move roughly in tandem with their broader industry group. As a result, it makes sense that investors should want to know which groups tend to perform best during various stages of the cycle. So where do most investors want to be in recovery?
The Very Early Recovery
The earliest stages of a recovery usually take place while everybody believes there is still a recession going on - it is usually only with backwards-looking data analysis that economists declare the end of a recession. Consequently, the very early recovery stage is usually marked by a mix of pessimism from those seeing a prolonged downturn (fretting over unemployment and consumer confidence), and optimism in those seeing a recovery just around the corner.
At this point in the cycle, interest rates are typically at the lowest levels of the cycle, as government officials attempt to stimulate demand, but most buyers are too nervous to commit to large-scale purchases.
Banks can do well in this very early stage, as a government's low interest rate policy reduces their cost of funds and provides a decent spread for bond holdings and mortgage lending. Utilities can also benefit in this phase, as investors are still drawn to the relative security of the businesses and the chatter that the companies (which often carry substantial debt loads) can benefit from the low prevailing interest rates.
The Recovery Stage
An economic recovery means that consumers are once again spending money and business are once again hiring people and thinking about expanding production. There is often still a lot of fear in this stage, but the prevailing thought is usually that the worst of the downturn is in the past. (What should you be watching for as the economy rebounds? Find out in The 6 Signs Of An Economic Recovery.)
Technology companies often see strong rebounds in the recovery stage of the cycle. During the descent into recession and throughout the recession, companies typically pare back their spending and make do with what they have. When business appears about to pick up, however, companies move to get ready - buying servers, software, and other types of technology hardware and services.
There is an element of chicken-versus-egg here - businesses resume their IT and technology hardware purchases in the recovery, and the recovery itself is sustained by these initial purchases. Nevertheless, technology stocks often outperform as companies make these initial "make-up" purchases. (For related reading, take a look at The Ups And Downs Of Investing In Cyclical Stocks.)
On the consumer side, too, there are often make-up purchases. Hearing talk on TV that the recovery is on and rates will probably start to rise again, consumers will go out and consider large-ticket purchases like automobiles or appliances. Likewise, consumers are often enticed to upgrade electronics like TVs, computers, or cell phones as they take advantage of sales with the idea that the malls will soon be filling up again and the good deals will go away. Much like in the case of business IT purchases, this is something of a self-fulfilling process - it is these purchases by those who went into hibernation during the recession that actually make the initial recovery happen and entice others out of the bunker mentality.
There Is No Silver Bullet
Investors should never lose sight of the fact that no two economic or business cycles are identical and the best that they can hope for is some general rules of thumb. The tepid recovery in the United States, for instance, saw the predictable rebound in technology company profits, but consumer spending has thus far not picked up to the level that many had predicted. On the other hand, transports have done better than might be traditionally expected at the same point in prior cycles.
Individual investors are probably better served by simply looking for the best companies they can find. If investors keep a close eye on what management is saying about near-term business conditions and do not forget the importance of valuation, they should be able to navigate the cycles while hanging on to high-quality businesses trading for reasonable valuations.
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