The Best Sectors for Stages in Economic Cycle

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Many investors fail at market timing; others never try it because they are afraid to risk losing their hard-earned savings to the whims of the stock market. In both cases, there is a lack of understanding of market and economic cycles and fundamental mistakes with asset allocation strategies.

Knowing which sectors that can outperform the stock market can be done in a smart way if you understand and observe the phases of the business cycle. For this reason, take a look at some of the basics of investing with mutual funds and then move on to learning more about investing with sectors.

Begin By Building a Smart Portfolio

Timing the market by investing in sector funds may sound risky or irresponsible on the surface but it can be done wisely. To build the best portfolio of mutual funds, you always begin with an asset allocation that is appropriate for your time horizon and risk tolerance.

For example, investors that may need to tap into their savings in less than 10 years should have a relatively conservative mix of stocks, bonds, and cash, compared to an investor with more than 10 years to invest. Also, if you get nervous every time you see your account balance drop, you likely have a low-risk tolerance which means your asset allocation should be relatively conservative, no matter what your time frame until withdrawal.

Once you arrive at an asset allocation, you are ready to build your portfolio. A good model for most investors to follow for portfolio construction is called a core and satellite structure. As the name suggests, you begin with a core, such as one of the best S&P 500 Index funds, and build around it with other funds. This is where sectors come into play: they can be some of the "satellites" that become a portion of a diversified portfolio.

Investing With Sector Funds

Sector Funds focus on a specific industry, social objective or sector such as health care, real estate or technology. Their investment objective is to provide concentrated exposure to specific industry groups, called sectors. Mutual fund investors use sector funds to increase exposure to certain industry sectors they believe will perform better than other sectors.

But how can an investor know which sector will perform best at a given time? Of course, there is no crystal ball when it comes to investing; no one knows with certainty what the stock market or economy will do, especially over short periods of time, such as one day, one month or even one year.

How the Stock Market Relates to Economic Cycles

Understanding the difference between market and economic cycles and how they are related to investment performance can help determine the best timing strategies and portfolio structure.

For example, did you know that a bull market for stocks typically peaks and can begin declining before the economy peaks? In different words, a new bear market for stocks can begin even as the economy continues to grow, although at a very slow pace. In fact, by the time the Federal Reserve officially announces a recession has begun, it could be a good time to get more aggressive and start putting more of your investment dollars back into stocks.

All investors, which includes individuals, asset managers, pension funds, banks, insurance companies, just to name a few, collectively make up and influence what most refer to as "the market." Technically the market refers to capital markets, which is a marketplace for investors to buy and sell investment securities, such as stocks, bonds, and mutual funds.

When you hear or read about reference to "the economy" it most often refers to what makes up an economic system, which includes consumers, industry, corporations, financial institutions, and government.

Choosing the Best Sectors Based On the Business Cycle Phases

In a big picture view, the place where the stock market and economy overlap is business. This is for many reasons but it is primarily due to the fact that business, meaning everything from small business owners to corporations, drive the economy and are the reason the stock market exists.

For this reason, investors can watch the Business cycle and choose sectors based upon historical trends within the different phases of the cycle:

  1. Early-Cycle Phase: The economy is rapidly recovering from recession. Credit markets begin to recover and grow as monetary policy is still easing (interest rates are falling), which adds money and liquidity to an economy weakened by the previous Recession Phase. As a result, corporate earnings are growing and consumers are spending. Best sectors include consumer cyclicals and financials. Bonds can also be good since bond prices generally rise as interest rates fall.
  2. Mid-Cycle Phase: This is typically the longest phase of the business cycle. The economy is stronger but growth is moderating. Interest rates are at their lowest and corporate earnings are at their strongest of the cycle. Best sectors include industrials, information technology, and basic materials. Begin to underweight bonds, as interest rates are moderating and possibly beginning to rise as the Fed tries to fight off inflation.
  3. Late-Cycle Phase: Economic growth is slowing and begins to appear overheated as inflation climbs higher and stock prices begin to look expensive compared to earnings (see S&P 500 Index P/E ratio). Best sectors in this phase include energy, utilities, healthcare, and consumer staples.
  4. Recession Phase: Economic activity and corporate profits are declining, the stock market may have already entered a major correction, and interest rates are at peak levels. Best sectors in this phase include the same sectors that began to gain favor in the Late-Cycle Phase. However, this phase is typically the shortest (usually less than a year) and moving into Early-Cycle Phase sectors can be considered.

Remember and Use the 5% Rule of Investment Allocation

A few questions may still be lingering in your mind, such as "How much of my portfolio should I allocate to each sector?" and "How many sectors should I use?" A general rule to follow is not to allocate more than 5% to any single sector and to avoid having more than 20% of your portfolio dedicated to sectors. Therefore, you can use between one and four sectors with 5% allocated to each.

The reason for this is that other stock funds that you may be using, such as S&P 500 Index funds, will have exposure to sectors as well and you do not want too much stock fund overlap, otherwise you will defeat a primary purpose of using sectors, which is diversification. Tactical and strategic investing is not just to boost returns; it's also for minimizing risk when possible.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.