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How to invest using the business cycle

Key takeaways

  • Economic conditions may affect investment performance.
  • Measures of economic activity have historically risen and fallen in a pattern known as the business cycle.
  • The business cycle contains 4 distinct phases: early, mid, late, and recession.
  • History offers guidance as to how various types of investments might perform during each phase.

Corporate earnings, interest rates, inflation, and other factors that change as economies expand and contract can affect the performance of investments. Understanding how various types of stocks, bonds, and other assets have historically performed at various points in the business cycle may help investors identify opportunities as well as risks.

Knowing the cycle may also help investors evaluate and adjust their exposure to different types of investments, as the likelihood of a shift from one phase of the cycle to the next increases. This business-cycle investing approach differs from both short- and long-term approaches because shifts from one phase of the business cycle to the next have historically taken place every few months or years on average.

Fidelity's Asset Allocation Research Team believes long-term historical average returns provide reasonable guidance for allocating assets in portfolios. However, over periods of 30 years or less, short-, intermediate-, and long-term factors may cause performance to deviate significantly from those averages, so analyzing factors and trends over shorter time periods can also be an effective approach to asset allocation.

Investment performance is driven by short-, intermediate-, and long-term factors

This chart shows that asset performance is driven by a confluence of various short-, intermediate-, and long-term factors.
For illustrative purposes only. Source: Fidelity Investments, Asset Allocation Research Team (AART).

Understanding business cycle phases

Every business cycle is different, but certain patterns have tended to repeat over time. Changes in the cycle reflect changes in corporate profits, credit availability, inventories of unsold goods, employment, and monetary policy. While unforeseen macroeconomic, political, or environmental events can sometimes disrupt a trend, these key indicators have historically provided a relatively reliable guide to recognizing the phases of the cycle. Bear in mind, though, that the length of each phase has varied widely.

A typical business cycle contains 4 distinct phases.

  • Early cycle: Generally, a sharp recovery from recession, as economic indicators such as gross domestic product and industrial production move from negative to positive and growth accelerates. More credit and low interest rates aid profit growth. Business inventories are low, and sales grow significantly.
  • Mid-cycle: Typically the longest phase with moderate growth. Economic activity gathers momentum, credit growth is strong, and profitability is healthy as monetary policy turns increasingly neutral.
  • Late cycle: Economic activity often reaches its peak, implying that growth remains positive but slowing. Rising inflation and a tight labor market may crimp profits and lead to higher interest rates.
  • Recession: Economic activity contracts, profits decline, and credit is scarce for businesses and consumers. Rates and business inventories gradually fall, setting the stage for recovery.

How investments have performed during each phase

Historically, different investments have taken turns delivering the highest returns as the economy has moved from one stage of the cycle to the next.* Due to structural shifts in the economy, technological innovation, regulatory changes, and other factors, no investment has behaved uniformly during every cycle. However, some types of stocks or bonds have consistently outperformed while others have underperformed, and knowing which is which can help investors set realistic expectations for returns. Recently, of course, COVID-19 has had a significant impact on investment performance.

Investments in the early cycle

Since 1962, stocks have delivered their highest performance during the early cycle, returning an average of more than 20% per year during this phase, which has lasted roughly one year on average. Stocks have typically benefited more than bonds and cash from the typical early cycle combination of low interest rates, the first signs of economic improvement, and the rebound in corporate earnings. Stocks that typically benefit most from low interest rates—such as those of companies in the consumer discretionary, financials, and real estate industries—have outperformed. Consumer discretionary stocks have beaten the broader market in every early cycle since 1962.

Other industries that typically benefit from increased borrowing—including diversified financials, autos, and household durables—have also been strong early cycle performers. High-yield corporate bonds have also averaged strong annual gains during the early cycle.

Investments in the mid-cycle

As growth moderates, stocks that are sensitive to interest rates and economic activity have historically still performed well, but stocks of companies whose products are only in demand once the expansion has become more firmly entrenched have also delivered strong returns. Annual stock market performance has averaged roughly 14% during the mid-cycle. Bonds and cash have typically posted lower returns than stocks but the difference in returns among the 3 has historically not been as great as during the early cycle.

Information technology stocks have been the best performers during this phase, with semiconductor and hardware stocks typically picking up momentum once companies gain confidence in the recovery and begin to spend capital.

At nearly 3 years on average, the mid-cycle tends to be longer than any other phase and is also when most market corrections have taken place. No single category of investments has outperformed the broader market more than half of the time during the mid-cycle.

Investments in the late cycle

The late cycle has historically lasted an average of a year and a half, with the overall stock market averaging an annualized 5% return. As the recovery matures, inflation and interest rates typically rise, and investors shift away from economically sensitive assets. Higher inflation typically weighs on the performance of longer­ duration bonds. Energy and utility stocks have done well as inflation rises and demand continues. Cash has also tended to outperform bonds, but investors should be cautious about making changes to their asset allocation in pursuit of opportunities during the late cycle.

Investments in recession

Recession has historically been the shortest phase of the cycle, lasting slightly less than a year on average and stocks have performed poorly with a −15% average annual return. Interest rates typically fall during recessions, providing a tailwind for investment-grade corporate and government bonds, which have outperformed stocks in most recessions. As growth contracts, stocks that are sensitive to the health of the economy lose favor, and defensive ones perform better. These include stocks of companies that produce items such as toothpaste, electricity, and prescription drugs, which consumers are less likely to cut back on during a recession. In a contracting economy, these companies’ profits are likely to be more stable than those of others.

High dividends paid by utility and health care companies have helped their stocks during recessions. Interest-rate-sensitive stocks including those of financial, industrial, information technology, and real estate­ companies typically have underperformed the broader market during this phase.

While every business cycle is different, an approach to investment analysis that identifies key phases in the economy and looks at how investments have performed in those phases in the past may offer investors guidance as they set expectations for their portfolios.

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The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation recommendations for Fidelity's portfolio managers and investment teams. AART is responsible for analyzing and synthesizing investment perspectives across Fidelity’s asset management unit to generate insights on macroeconomic and financial market trends and their implications for asset allocation. Lisa Emsbo-Mattingly, director, Dirk Hofschire, CFA, SVP; Austin Litvak, senior analyst, and Joshua Lund-Wilde, analyst contributed to this report. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

Past performance is no guarantee of future results.

Neither asset allocation nor diversification ensures a profit or guarantees against a loss.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Each sector investment is also subject to the additional risks associated with its particular industry. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. All indexes are unmanaged. You cannot invest directly in an index. Performance in this paper is based on index performance and does not reflect the performance of actual investments. The analysis does not reflect taxes or transaction costs, which would reduce performance. The Typical Business Cycle chart depicts the general pattern of economic cycles throughout history, though each cycle is different. In general, the typical business cycle demonstrates the following: • During the typical early-cycle phase, the economy bottoms and picks up steam until it exits recession and then begins the recovery as activity accelerates. Inflationary pressures are typically low, monetary policy is accommodative, and the yield curve is steep. • During the typical mid-cycle phase, the economy exits recovery and enters into expansion, characterized by broader and more self-sustaining economic momentum but a more moderate pace of growth. Inflationary pressures typically begin to rise, monetary policy becomes tighter, and the yield curve experiences some flattening. • During the typical late-cycle phase, the economic expansion matures, inflationary pressures continue to rise, and the yield curve may eventually become flat or inverted. Eventually, the economy contracts and enters recession, with monetary policy shifting from tightening to easing. Please note that there is no uniformity of time among phases, nor is there always a chronological progression in this order. For example, business cycles have varied between 1 and 10 years in the US, and there have been examples when the economy has skipped a phase or retraced an earlier one. * Source: Fidelity Investments (AART), 2020. See the latest monthly “Business Cycle Update,” Fidelity Investments (AART), for a complete discussion of current trends. Sectors and industries are defined by the Global Industry Classification Standard (GICS®). The S&P 500 Sector Indices include the 10 standard GICS® sectors that make up the S&P 500® Index. The market capitalization of all 10 S&P 500 Sector Indices together compose the market capitalization of the parent S&P 500® Index; all members of the S&P 500® Index are assigned to 1 (and only 1) sector. Sectors are defined as follows: Communication Services: companies that facilitate communication or provide access to entertainment content and other information through various types of media. Consumer Discretionary: companies that provide goods and services that people want but don’t necessarily need, such as televisions, cars, and sporting goods; these businesses tend to be the most sensitive to economic cycles. Consumer Staples: companies that provide goods and services that people use on a daily basis, like food, household products, and personal-care products; these businesses tend to be less sensitive to economic cycles. Energy: companies whose businesses are dominated by either of the following activities: the construction or provision of oil rigs, drilling equipment, or other energy-related services and equipment, including seismic data collection; or the exploration, production, marketing, refining, and/or transportation of oil and gas products, coal, and consumable fuels. Financials: companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, and insurance and investments. Health Care: companies in 2 main industry groups: health care equipment suppliers and manufacturers, and providers of health care services; and companies involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products. Industrials: companies whose businesses manufacture and distribute capital goods, provide commercial services and supplies, or provide transportation services. Materials: companies that are engaged in a wide range of commodity-related manufacturing. Real Estate: companies in 2 main industry groups—real estate investment trusts (REITs), and real estate management and development companies. Technology: companies in technology software and services and technology hardware and equipment. Utilities: companies considered to be electric, gas, or water utilities, or companies that operate as independent producers and/or distributors of power. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC.

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