Sector investing involves buying stocks within specific economic sectors which are expected to outperform given current market trends and economic conditions. This investment strategy utilizes a top-down approach to stock picking, starting with understanding the prevalent macroeconomic trend and which sectors it favors, and then identifying fundamentally strong companies in that sector with high growth potential.

Essential to sector investing is understanding that various sectors perform differently across each unique business cycle phase. Knowing what characterizes the stages of the business cycle and how they impact economic sectors is the primary step in adopting this approach to managing your portfolio.

The Business Cycle Explained

The business cycle is a term economists use to describe a recurring pattern of alternation between increases and decreases in aggregate economic activity over a period of time. Also known as the economic cycle, this pattern is referred to as a cycle because it takes a circular movement of an economy as it moves from one phase to another and back again. However, slight variations often exist across each sequence, especially in the length of time it takes for a cycle to be completed or the economic impact observed in a sector as business models evolve in light of new technologies.

Factors such as industrial production (GDP), interest rates, total employment, and consumer spending are analyzed by economists, investors, and businesses to measure economic activity and determine the current phase of the business cycle.

Phases of the Economic Cycle

The economic cycle moves between two major points: economic expansion which is characterized by growth in business activity until it reaches its peak, it is then followed by economic contraction which is marked by a decline in economic activity leading to recession.

1. Expansion: In this stage, the economy experiences rapid growth, marked by low-interest rates, and an increase in industrial production. The overactive market activity increases the supply of money in the economy as inflationary pressures mount.
2. Peak: The peak of the business cycle is the point where the economy hits its maximum. At this phase, consumer spending and production output have reached their limits as the inflation rate spikes.
3. Contraction: To correct the imbalances caused by an overheated economy, the contraction phase introduces an economic slowdown marked by reducing production output, falling employment rates, and stagnant prices. Economic recession is a typical characteristic of this phase and many times lead to severe economic depression.
4. Trough: The trough of the economic cycle is reached when the economic recession hits its lowest point with the economic growth rate at a negative. This phase marks the end of a period of declining business activity.
5. Recovery: The recovery phase begins as the economic recession comes to an end and business activity begins to improve. It is marked by a growth in GDP, income as well as employment rates. As the economy rebounds, it adapts to the initial conditions that triggered the recession.

Stock Market Performance Vs Business Cycle

 As the economy changes over various phases of the business cycle, so do the stock performances in various sectors. Typically, economically sensitive sectors like financials and information technology outperform other sectors during economic expansion while defensive and more stable sectors such as consumer stables and healthcare can withstand economic decline much better.

Economic Expansion  (Early-to-Mid Cycle)

The expansion phase is the period where an economy rebounds from the recession and begins to experience rapid growth, with the cost of borrowing becoming more favorable as the Central Bank eases the monetary policies which were in place to cool off the overheated economy and correct inflationary pressures. The is allows companies to lower their costs and expand rapidly income, causing employment and income rates to rise. The best-performing sectors during the early stages of economic expansion include the consumer discretionary sector, information technology, financials, as well as industrials and basic materials sectors. This is because rapid business growth increases the demand for information and communication services, as well as manufacturing and construction. Also, higher income increases consumer spending power for non-essential goods.

Usually, the mid-cycle which sees the peak of economic growth until a slowdown begins is the longest stage in the economic cycle. During this period steady growth is seen across sectors without one significantly outperforming others. It is wiser to adjust asset allocation at this stage to minimize risk.

Economic Contraction (Late Cycle)

The late cycle sees a slowdown in the rate of economic growth as business activity and earnings begin to fall while inflation climbs higher. This stage is one for investors to seek defensive and inflation-resistant sectors, such as consumer staples, health care, utilities, and energy.

Recession 

With the economy shrinking in the recession stage, business activity and income fall with Interest rates at peak levels. No sector typically does well in this period, and it is important to find historically stable sectors that are highly defensive against volatility. These include sectors that people need regardless of economic conditions like health care, utilities, and consumer staples.

Sector Analysis with Anahit

Analyzing a sector based on how the business cycle works not only helps you to understand when to make investments and when to make an exit, but it can also help you identify winning sectors that are worth your money. 

Anahit is an asset analysis platform that can help you determine how the current economic conditions can impact the current and future performance of a potential asset. Using proprietary AI algorithms, Anahit enables you to analyze macroeconomic indicators for various sectors and observe statistical trends for a stock from years of market data to make stronger predictions on the direction of the stock market.

Make confident investment decisions. Sign up to Anahit today and get a 6-month free trial. Visit Anahit.ai.