The seemingly endless tug of war between the bulls and bears on Wall Street can be frustrating for even the most patient investors, which is why arming yourself with knowledge about how previous economic recoveries have played out can give you an edge. Business cycle analysis can help ETF investors distinguish between different phases of economic expansion and contraction, helping to pinpoint sectors of the market that perform better than others throughout certain phases [see 101 ETF Lessons Every Financial Advisor Should Learn].
As such, there are two pressing questions that must be answered at any point in time before jumping into an investment. First, what part of the business cycle are we in now? And the logical follow up is what asset classes should investors over or underweight during the coming months in an effort to favorably position themselves?
What Part Of The Business Cycle Are We In?
Economists and market analysts use a variety of data points, indicators, and approaches when it comes to identifying where we currently are in the business cycle, and while this is far from an exact science, there are generally accepted principles that hold historical significance. In its simplest form, the business cycle is another way to look at gross domestic product (GDP); the cyclical tendency of GDP is what allows investors to distinguish between periods of expansion and contraction [see also Visual Guide: Major Index Returns by Year from 1970].
Changes in key economic indicators have historically provided a reliable guide to recognizing the different phases, which are early, mid, and late expansion, and also recession. So where are we now? The short answer: mid-cycle expansion.
How can you tell? GDP is positive and slowly trending higher, the housing market and manufacturing data continue to show signs of recovery, while consumption and employment levels still have plenty of room for improvement. One of the simplest indicators that many rely on to distinguish between cycles, as well as identifying transitions between phases, is the Leading Economic Index; this popular gauge is made up of 10 components and covers everything from average work week hours to new orders for durable goods to interest rate spreads [see 3 Contrarian Indicators ETF Investors Must Know].
There is no specific set of criteria to pinpoint the exact transition from mid to late expansion (or any other phase for that matter), and because every recession and recovery is inherently unique, investors who wish to employ business cycle analysis need to do their homework and stay on top of all major data releases in lieu of relying on others interpretations of them.
What Sectors Perform Best In The Middle Phase of Recovery?
After you determine where we are in the cycle, the next question is what sectors do you buy/sell/hold to reap the greatest returns possible over the coming months as we progress further into the mid-phase, inevitably approaching the late-phase (also known as the peak). As such, below we highlight three sectors that are poised to outperform broad equity benchmarks as the economic recovery takes full root [see also Picture Edition: 3 Market Valuation Indicators ETF Investors Must Know].
For anyone interested in learning more about the business cycle and how it can help with their asset allocation strategy please refer to How To Invest In Sectors Using The Business Cycle. Note that the historical sector performance analysis below is based on research by Fidelity:
The industrial sector generally sees an uptick during the mid-phase as the economic recovery takes deeper root. Signs of improving growth on the horizon typically prompt an increase in manufacturing activity as businesses and consumers once again start to make more expenditures. State Street’s (XLI, A) is the biggest fund in the space while the PowerShares S&P SmallCap Industrials Portfolio (PSCI, A) is the most popular option for risk-tolerant investors [see 3 Sector Rotation Strategies ETF Investors Must Know].
Technology stocks, especially those in the Information Technology corner, have a track record of outperforming the broad market in the mid-phase for a similar reason to the industrials; businesses generally start to spend more on technology-related products and services only once the economic recovery has taken full root, and improving growth prospects are on the horizon. The PowerShares (QQQ, B+) is the most popular option for accessing the coveted NASDAQ 100 Index, while Vanguard’s Information Technology Index Fund (VGT, A+) is another very popular option that offers a bit more targeted exposure.
The financials sector is not highlighted in Fidelity’s research as being a consistent outperformer during the mid-phase. However, seeing as how the recent recession started in this corner of the market, we feel that the financials sector still has plenty of room for growth; with interest rates still hovering at record lows, banks have yet to see a meaningful jump in profitability since the depths of the recession. State Street’s (XLF, A) is the biggest and most actively traded option in this space while the Bank ETF (KBE, A) is another popular choice that offers more targeted exposure [see also 17 ETFs For Day Traders].
The Bottom Line
While no recession or recovery are identical to previous ones, there are certain trends in each of the expansion and contraction phases that can offer investors valuable insights. Being aware of where we are in the business cycle can help you more favorably position your portfolio; more specifically, investors can have better insights as to what sectors have a historical tendency to lead, or lag, during certain phases of the recovery.
As always, investors of all experience levels are advised to use stop-loss orders and practice disciplined profit-taking techniques.
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Disclosure: No positions at time of writing.