The U.S. economy is divided into different sectors, such as financial and industrials, that are affected over time by changes in the business cycle. Business cycles, which last between one and ten years, are sometimes internally driven by government or central bank policy, while at other times cycle changes are driven by external or global factors. For example, a slowing demand for commodities in China can affect Australia's economy, which is a large exporter of raw materials. Or a strong U.S. dollar may decrease demand for exports and affect the profitability of multi-national companies, such as Proctor and Gamble (PG).
Economic and Business Cycles
The business cycle can be broadly classified as: Recession, Recovery, Expansion and Slowing. (See also: Macroeconomics: The Business Cycle)
- Recession is when the pace of a country’s economic growth slows and corporate profits begin to decline. Product and service sales decrease, inventories begin to fall and monetary policy leans towards making money more readily available to try and spur growth.
- Recovery follows recession as early signs of economic growth arise. The availability of credit through lending increases, demand for products and services begins to increase, and corporate profits start to grow.
- Expansion follows recovery as the demand for products and services accelerates and inventories are growing. To control economic growth and inflation, government or central bank policy begins to tighten the money supply and restrict credit.
- Slowing is the period when economic growth peaks and begins to falter. Corporate profits start to shrink as demand for products and services declines. Inventories begin to grow as demand decreases leading to a recession.
There is no set timeline for how long each part of the business cycle lasts. Since 1970, seven recessions have occurred, ranging in duration from less than six months to more than 30 months. In hindsight it is easy to determine when cycles begin and end. However, in real time it’s difficult to precisely pin down shifts in the business cycle. The one constant is that the cycles do change and have a predictable effect on each sector of the economy.
The U.S. economy is divided into the following broad sectors: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrial, Information Technology, Materials and Utilities. Each sector includes multiple lines of business. For example, healthcare includes bio-tech and medical devices; the financial sector includes banks and insurers; and consumer discretionary includes Internet and catalog sales.
From an investment perspective, history has shown that certain sectors of the U.S. economy tend to consistently provide higher or lower returns at different points in the business cycle. For example, historical data compiled by Fidelity Investments going back to 1963 shows that:
- The Financial, Consumer Discretionary, Information Technology and Industrial sectors tend to do well in a recovery.
- During an expansion, Information Technology, Energy, Materials and Industrials outperform.
- A slowing economy tends to favors the Energy, Materials, Consumer Staples and Healthcare sectors.
- In a recession, defensive sectors including Consumer Staples, Healthcare, Utilities and Telecommunications tend to provide the best return.
Rather than trying to select individual stocks or mutual funds with specific investment styles (growth or value) or asset classes (small or mid-cap); sector investing is about trying to be positioned in the right place at the right time. Fortunately, there are a wide range of mutual funds and exchange traded funds (ETF), such as the Select SPDR ETFs, that make it easy to quickly move in and out of specific U.S. market sectors. Many of the mutual funds offer an opportunity for more active management, while the ETFs usually track an index. In addition, some funds and ETFs offer more focused allocations, such as biotech or real estate. (See also: An Introduction to Sector Mutual Funds)
Initially, the sector investing process requires you to assess the current stage of the U.S. business cycle. For instance, if you believe that in 2016 the U.S. is in late expansion heading into a period of slower growth, you would allocate accordingly. However, any analysis also needs to take into consideration how shifts in monetary policy may effect a given sector. For example, how might an increase in U.S. interest rates by the Federal Reserve affect consumer spending, as well as the housing and auto industries?
Like any investment strategy, sector investing has inherent risks. It’s difficult to precisely time shifts in the business cycles, and having concentrated exposure can result in large and sudden price swings, such as the boom and bust in the energy sector that started in 2015. Other factors to consider may include:
- The correlation between sectors. For example, Consumer Staples have a relatively low correlation with the Telecommunication and Utility sectors.
- Many sectors, such as technology and industrials, require significantly more time to ramp up or slow down production as compared to the Consumer Discretionary sector.
- How shifts in government or central bank policy may affect a sector. For instance, an increase in U.S. interest rates (or speculation on future rate increases) can cause the financial sector to spike upwards and support a strong dollar, which may affect U.S. exports and emerging market economies.
The Bottom Line
Sector investing can be an effective investment strategy, but you need to stay attuned to economic and business news and be prepared to make allocation changes.