The myriad of factors that change as economies expand and contract affect the performance of investments. Understanding how different types of investments have historically performed at various points in the business cycle can assist investors in identifying opportunities as well as risks. Understanding the cycle can also help investors reevaluate and adjust their portfolio as the likelihood of a shift into the next phase of the cycle increases.
At Bell Capital we believe long-term historical average returns can provide guidance for allocating assets in portfolios. That said, over periods of 30 years or less a number of factors may cause performance to deviate significantly from those averages, so it is important to factor in short-term trends and anomalies.
The phases of the business cycle
The specifics vary from business to business, but certain patterns tend to repeat over time. Changes in the cycle reflect changes in monetary policy, corporate profits, credit availability, inventories of unsold goods and employment. Whilst unforeseen events have the potential to disrupt trends, these key indicators have historically provided a relatively reliable guide to recognizing the phases of the cycle. The length of each phase can vary widely on each time through the cycle.
A typical business cycle contains 4 distinct phases.
Early cycle: Generally, a sharp recovery from recession, as economic indicators such as GDP and industrial production move from negative to positive and growth accelerates. Low interest rates and increased borrowing aid profit growth. Business inventories are low, and sales increase significantly.
Mid-cycle: Usually the longest phase with moderate growth. Economic activity picks up 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.
Investing during the early cycle
Since 1962, stocks have consistently delivered their best performance through the course the early cycle, returning over 20% per year on average during this phase, which has historically lasted for around one year on average. Stocks can be expected to benefit 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.
Other industries that typically benefit from increased borrowing – such as diversified financials, autos, and household durables – have also typically been strong performers during the early cycle. Additionally, high-yield corporate bonds have averaged strong annual gains during this phase.
Investing during the mid-cycle
As growth starts to slow down, stocks that are sensitive to interest rates and economic activity can be expected to still perform well, but strong returns can also be expected from stocks of companies whose products are only in high demand once expansion has taken place. 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.
Investing during the late cycle
The late cycle has historically lasted for a year and a half on average. As the recovery matures, inflation and interest rates usually start to rise, and investors pull away from economically sensitive assets. Energy and utility stocks have done well as inflation rises but demand continues, whilst cash has tended to outperform bonds.
Investing during recession
Recession is usually the shortest phase of the cycle, lasting slightly less than a year on average. Stocks tend to perform badly during recession with a −15% average annual return, whilst investment-grade corporate and government bonds usually outperform stocks due to low interest rates. Stocks that are sensitive to the health of the economy naturally fall out of favor during this phase, and defensive ones perform better.
The high dividends paid by utility and health care companies have typically helped their stocks during recessions. Interest-rate-sensitive stocks such as those of financial, industrial, information technology, and real estate companies have usually underperformed the broader market during this phase.
Conclusion
Whilst every business cycle is different, identifying key phases in the economy and understanding how investments have performed in those phases in the past can offer investors guidance as they set expectations for their portfolios.
Analysis of the business cycle forms just one small part of the extensive research undertaken by Bell Capital. Contact us today for more information on how we can help you achieve your financial goals.
