Leveraging the Business Cycle in Sector Investing

Performance in varying segments of the economy often depends on timing.

Knowing how the business cycle affects fundamentals in different sectors can help investors enhance their returns and reduce their risks.

Some sectors are cyclical, that is, company fundamentals are heavily affected by the business cycle. Others are more defensive; their sales and profits are somewhat immune to economic ups and downs.

But the stock market is also forward-looking. So, stocks may rise or fall independently of the business cycle. That is, they may move in anticipation of the business cycle’s next phase. For example, even though consumer discretionary companies (restaurants, hotels, specialty retail) struggle during recessions, their stocks may perform well if investors buy them in anticipation that sales and profits will improve when the economy rebounds.

What are sectors?

Investors use a variety of sector and industry classification systems. Standard & Poor’s Global Industry Classification System is one of those used most widely. Here are the 11 sectors in that system:

Information Technology

Health Care

Financials

Consumer Discretionary

Communication Services

Industrials

Consumer Staples

Energy

Utilities

Real Estate

Raw Materials

Cycle refresher

Late-cycle

Higher input costs and a tight labor market may squeeze profit margins, and the central bank may raise interest rates to curb inflationary pressures often leading to a recession. This phase persists for about one and a half years, on average.

Recession

The economy contracts, corporate profits decline, and lending becomes more constrained. Historically, recessions tend to last less than one year.

Mid-cycle

Economic activity continues to grow, and profitability is healthy while the monetary policy backdrop becomes less stimulative. The length of this phase averages about four years.

Early-cycle

Low interest rates, implemented to end a recession, help produce a healthy environment for growth. On average, this phase lasts about one year.

Source: Fidelity, The Business Cycle Approach to Equity Investing, 2021.

Typical sector performance through the business cycle

In 2021, analysts at Fidelity Investments researched the historical performance of various sectors, concluding that “the business cycle can be a critical determinant of equity sector performance over the intermediate term.” Here are highlights from their analysis:

Recession: Defensive sectors, including health care, utilities, and consumer staples, tend to perform well. Consumer discretionary may also benefit as investors look ahead to the next economic expansion. Economically sensitive sectors such as financials, real estate, and technology have lagged, historically.

Early Cycle: Cyclical sectors, such as financials (especially banks), which are more sensitive to interest rates and to the economy, tend to outperform. Others that historically have performed well include real estate, consumer discretionary, technology, industrials, and materials. Defensive sectors — health care, consumer staples, and utilities — tend to lag.

Mid Cycle: In this phase, interest rates are still low and corporate income is strong. But economic growth begins to moderate, and investors may want to begin to reduce their exposure to cyclical sectors, which are likely to decline as the expansion matures. Historically, communication services and technology have been strong performers.

Late Cycle: If inflation becomes a problem, sectors that are inflation-resistant, such as real estate and energy, may benefit. Historically, consumer staples and utilities have also done well.

Sector performance through the business cycle (chart)

Sector performance in 2022

High-flying technology and Internet stocks have sold off and energy stocks have boomed. In fact, as of August 31, the S&P 500 index was down by more than 17% (year to date), and only two of 11 sectors in this widely used benchmark had posted positive returns.

Consistent with an economy in the late-cycle phase, energy and utilities stocks have outperformed this year. But with the economy potentially in recession, defensive sectors, including consumer staples and health care, have also performed well on a relative basis, losing less than most others.

Sector 1-year percent change as of August 31, 2022

S&P 500 Index -17.02%

Communication Services -29.64%

Consumer Discretionary -23.61%

Consumer Staples -4.07%

Energy +48.02%

Financials -14.64%

Health Care -10.81%

Industrials -11.51%

Materials -15.93%

Real Estate -18.71%

Information Technology -21.87%

Utilities +5.34%

Source: Select Sector SPDRS, as of August 31, 2022.

How to invest

A key tenet of investing is to remain diversified. So, avoid putting too much into a single investment. Some advisers suggest you allocate no more than 5% to any one stock and no more than 20% to any one sector.

Dozens of sector-based mutual funds and ETFs are readily available from a variety of investment firms. Here are two research resources investors can turn to: VettiFi (formerly ETF Database) at etfdb.com offers a comprehensive list of sector ETFs.

US News & World Report at money.usnews.com/investing offers rankings of both sector mutual-funds and ETFs.

LARGEST FUNDS BY AUM FOR 3 TOP SECTORS

Among U.S. News & World Report’s ‘Best Funds’ Rankings

Mutual Funds

Energy

Vanguard Energy Index Fund (VENAX), Assets under management $8.1 billion, Expense Ratio 0.10%, 1-year return 80.8%

Utilities

Franklin Utilities Fund (FKUTX), Assets under management $7.2 billion, Expense Ratio 0.72%, 1-year return 15.1%

Consumer Staples

Vanguard Consumer Staples Fund (VCSAX), Assets under management $6.9 billion, Expense Ratio 0.10%, 1-year return 7.2%

Exchange-traded funds

Energy

Energy Select Sector SPDR (XLE), Assets under management $38.6 billion, Expense ratio 0.10%, 1-year return 79.8%

Utilities Utilities Select Sector SPDR (XLU), Assets under management $17.9 billion, Expense ratio 0.10%, 1-year return 14.8%

Consumer Staples Consumer Staples Select Sector (XLP), Assets under management $16.3 billion, Expense ratio 0.10%, 1-year return 8.2%

Source: U.S. News & World Report, Morningstar, Standard & Poor’s. Data as of August 24, 2022.

COMPARISON CHECK

-12.55% Total 1-year return for Standard & Poor’s 500 Index as of August 31, 2022

Kiplinger October 2022, Future US LLC