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Financial Advice from Yoke M. Allen

Business Cycle Offers Clues to Investment Opportunities

Business activity tends to go in cycles, and understanding the stages of a business cycle can provide clues that may help you identify favorable investment opportunities. While some stocks tend to be immune to economic swings, others perform better or worse during different stages of the business cycle.

The business cycle can provide insight, but it is important to realize that the U.S. economy rarely follows this cycle precisely, and that the amount of time spent in each stage of the cycle varies. In addition, the economy does not always expand to its fullest levels, nor does it always dip into recession. It does, however, tend to proceed through six typical stages. Here are some general guidelines to which market sectors are inclined to benefit in each cycle.

• Stage 1: Economic Slowdown In a period of economic slowdown, utilities and financial company stocks usually react favorably as it becomes clear to investors that the economy is sluggish. Long-term interest rates peak, and shorter rates begin to fall as the Federal Reserve implements strategies to stimulate the economy. Thus, investors often buy interest-rate sensitive stocks. Utilities, which generally have high debt levels, benefit as rates decline. Financial companies also benefit as rates (and therefore, their cost of funds) decrease and loan demands increase.

• Stage 2: Anticipated Recovery With anticipated economic recovery, consumer stocks typically rise, as low interest rates encourage consumers to spend more. Stock prices are generally very low during this stage of the economic cycle.

In a mid-cycle recovery, interest rates begin to go up, and early signs of inflation emerge. At this stage, stocks generally perform better than bonds. Industrial companies, such as electrical equipment, machinery and construction come into favor.

• Stage 4: Full Expansion During the full expansion stage of the business cycle, interest-rate sensitive stocks generally peak by the time the cyclical expansion is fully under way. Opportunities may appear among companies that benefit during higher inflation and in higher interest-rate environments, such as chemical, technology and energy stocks.

• Stage 5: Economic Peak At the economic peak of the cycle, the major stock market indexes may dip below their 12-month moving averages. Basic materials companies (including chemicals and metals) and energy stocks are often favored by investors since inflation is probably peaking during this cycle.

• Stage 6: Economic Decline When the business cycle reaches economic decline, investors attempt to protect their portfolios as the economy slows by moving back into “early-cycle” stocks, beginning with consumer non-cyclicals, which are companies that sell products and services whose demand is not tied to the economic cycle.

The Cycle Is Not Precise

While tracking the business cycle can be a useful barometer for investors, keep in mind that the business cycle is not precise. In addition, pinpointing particular stages of economic activity is not always easy and even economists do not always agree on exactly where the economy stands in any particular cycle.

Reach Yoke Allen by e-mail at yoke.allen@morganstanley.com