Three Key Cycles That Shape Market & Sector Trends

Most investors have placed a great deal of emphasis on ways to identify the right stocks to invest in, which are more of a bottom-up approach in investing. This would essentially mean that these investors conduct research and analysis on individual shares and companies. Selection of shares is made based on the respective company’s future prospect and ability to grown even when its industry is not performing very well as opposed to assessing the overall economic environment, which is what top-down investing entails. Investors who practice this approach, however, should not lose sight of macroeconomic factors. This is necessary as they are critical to the overall stocks performances.

Looking back, not too far back, rather just two years ago (2007), you would have noticed that the stock market was on an uptrend and everyone was still very upbeat about stock investing. You may have been one of them - you managed to identify a very good fundamental transportation stock and invested in it. Very soon after, the fuel price continued to increase and so did the inflation rate. However, your stock price took the opposite direction. You must have wondered why that was the case. Fundamentally, there was nothing wrong with the company, just that the overall economy was affected by the increasing inflation and market expected that the transportation business was soon to be affected by fuel hike.

Hence, it is also critical for investors to understand the overall economic factors and as such we will be looking at the three critical cycles that affect all businesses, either positively or negatively. These are the business cycle, stock market cycle and interest rate cycle.

Business cycle
A business cycle is essentially a recurring and fluctuating levels of economic activity that is experienced by an economy over a long duration and typically encompasses the following:

Recovery
- This is where the economy starts to work its way up to better financial footing after the previous recession period
Expansion
- Here, there would be increasing growth in demand resulting from increased customer confidence
Peak(also known as the economic boom)
- This is where demand surpasses the supply of goods and services in the market, unemployment is low and almost all the production capacity is fully utilised. During this period, we will see increasing inflation rate, which will later trigger central banks to raise interest rate when an economy is deemed to be overheated.
Contraction
- With higher interest rate, we will start to see slow down in capital purchases and inventory build up, followed by slow down in production. This subsequently leads to increasing layoff.
- Depending on the severity, during the contraction period, there could be just a slow down in economic activities or a recession, which is generally defined as negative economic growth for more than two consecutive quarters.
- At the trough of this, what is typically observed are businesses restructuring and consumers clearing off debts which they accumulated earlier. After going through a consolidation period, consumers would regain their confidence and start spending. Then, the cycle begins again.
However, very much like us human beings, no two business cycles are exactly the same. Even though all cycles might go through the phases described above, the length and width of the cycles are never the same but generally, the expansion period would be more gradual and longer compare to the contraction period.

Interest rate cycle
This is a cycle that is closely related to the economic activities. A typical interest rate cycle consists of 4 stages:

A series of rate hikes
A period of stabilisation
A series of rate cuts
A period of stabilisation
Usually, when a country’s inflation rate rises due to demand-pull pressures, its central bank will raise the interest rate to fight off inflation and cool down the economy. Here, the sectors hardest hit would be banking, automotive and housing, as higher interest rates make loans more expensive. As such, consumers would cut down on purchases from these sectors resulting in the earnings of companies in these industries taking a tumble. As the effect starts to take place with the economy slowing down, the interest rate will be held steady for a while up until a stage where by the economy slow down has gone into a more serious recession. This is when central banks react to lower interest rate to boost up its country’s economic activities. After the economy recovery is in sight, the interest rates would once again, be held steady until the next cycle comes.

However, there are certain times when the above does not happen. There are instances where, even though a country’s inflation goes up high, its central bank holds on to its current interest rate as the reason for the rising inflation was more due to cost-push effect, resulting from sharp increase in fuel price for example, rather than demand-pull pressure.

Stock market cycle
A most prominent feature of a stock market cycle is that the stock market cycle moves in tandem with the business cycle, and the former is always ahead of the latter. Why is that so? A very simple reason really - the stock market cycle reflects the overall market expectation on the business performance. Hence, when the market expects an economic boom is coming, before it actually hits, the stock market is already on its way up. The reverse happens before a recession. Therefore, if you trace a stock market cycle, you will see that its peak precedes the actual economic boom while stock market index hits the bottom before our economy goes to its trough. As such, the stock market index functions as an excellent leading indicator for the movements in a particular business cycle.

A typical stock market cycle goes through bull and bear periods. Within the bull period, it can be further classified into early bull, middle bull and late bull before reaching the peak. The same can be seen for the bear period; it consists of early bear, middle bear and late bear before hitting the bottom.

What is the significance of these three cycles to investors?
What is the benefit of knowing these three inter-related cycles - how does it help stock market investors? Investors who study the economy and market performance carefully would notice that at each stage of the stock market cycle, companies in certain industries tend to perform better than other industries in the market. By understanding the reasons behind it, they can put in place a stock rotation strategy, which basically means investing in different industries at different stages of the cycles.

In general, when the stock market is at its peak, moving from late bull into early bear, the business cycle is usually at the late expansion period, reaching its peak. This could happen when the fuel price is increasing and inflation is going up, which results in falling consumer expectation. Foreseeing that interest rate is going to increase, which will cause the economy to slow down, investors would tend to shy away from interest-rate sensitive sectors, such as banking, automotive and housing knowing that these industries will be hit badly during recession. They then would put their money into defensive stocks, such as consumer staples, food and healthcare which are non-cyclical.

As an economy moves into recession, its stock market would thus be in its middle and late bear periods. At this stage, companies will usually take cost cutting measures like reducing headcount, which results in increase in unemployment rate. This results in the consumers becoming more cautious, leading them to spend less on capital items even though there is a reduction interest rate. Investors would naturally try to profit from utilities stocks which benefit from cheaper interest cost. As the economy continues into its late recession, interest rate should then be at its lowest and fuel price would drop as well, due to lower demand. This in turn, would start to spur some interest from consumers again. Anticipating a turn around in the economy soon, investors would typically rotate their funds into cyclical industries, transportation, followed by technology with the expectation that businesses are out of the woods and consumers have regained their confidence.

When an economy enters recovery period and is going into expansion, demand for goods and services increases. Here, the stock market would experience the middle to late bull stages. This is where investors tend to rotate their funds into equipment and machineries as well as basic industries and materials, expecting production soon to prepare for the capacity increase to meet higher demand.

As business cycles are ever changing, the sector rotation patterns stated above may very well not recur in each and every cycle. However, what is of importance to investors here is that they understand the logic behind each pattern and study the broad economic situation before making investment decisions, while remembering to study the fundamentals of the companies before investing.

In addition to the above, investors would also need to pay attention to happenings which are not cyclical, such as the current US financial crisis which has spread globally. In such a situation, there is no certainty as to the extent of the crisis on other economies across the globe. Wise investors would, under such circumstances, best adopt the approach of “wait and see” until a clearer picture is in place. This is also when, cash is King!