How To Gain From Market Changes With Business Cycle Investing

Every economy is constantly in a state of flux, moving from one phase to another. These phases can be described as recovery, expansion, recession and slump. Understanding these phases can help an investor decide which phase of the business cycle an economy is in. Based on this understanding, an investor can optimize his/her portfolio. In effect, business cycle investing is a strategy that aligns investment decisions with the macroeconomic environment. Different sectors behave differently during different phases of the economy.

Economic Cycles and Sectors

The economic cycle serves as the foundation for identifying sectors that are likely to thrive or struggle. Let’s consider some typical sectoral behaviours in these four phases:

Recovery

During recovery, the economy begins to rebound from a slowdown, favouring cyclical stocks like industrials and some consumer discretionary stocks. Additionally, financials may benefit from increased activity.

Expansion

As recovery progresses into expansion, cyclical sectors maintain momentum while broader consumer discretionary categories (luxury goods, automobiles) thrive. Demand for metals and real estate also rises to support growth.

Recession

In this period, defensive sectors like utilities, consumer staples, technology and healthcare show resilience.

Slump

During this phase, sectors that cater to essential needs are the most likely to weather the storm. Pharmaceuticals, consumer staples and technological companies are likely to perform well.

Challenges

While identifying these phases may look simple and straight forward, many investors struggle when it comes to selecting the sectors that stand to gain or lose in each of these phases. This is because most investors select stocks based on recent returns, which can be misleading when investing based on business cycle as sectors that outperformed in the previous cycle may not replicate their performance as the phase changes. Another practical challenge for a lay investor is that when tweaking investments based on market cycles, each sell transaction may attract short-term capital gains (STCG) or long-term capital gains (LTCG), which will impact the overall investment return.

Business Cycle Fund as a Solution

In the light of these challenges, the optimal approach would be to invest in funds which invest based on business cycles. Here are a few key advantages of this approach:

Macroeconomic Expertise: Fund managers specializing in business cycle investing possess the expertise to analyse economic indicators, interpret macroeconomic trends, and identify cycles before they turn and reposition the portfolio accordingly.

Dynamic Rebalancing: These funds actively adjust sector allocation in response to shifting cycles which helps to optimize returns. When the portfolio is churned, an investor does not have to pay taxes on the gains. The investor only has to pay taxes only at the time of redemption.

Diversification: Even within the business cycle framework, a fund maintains exposure to a bunch of sectors, which helps mitigate risk and volatility.

Crucial Considerations

Before investing in a business cycle fund, one has to understand the risk profile of the fund and decide if it matches one’s risk tolerance or not. An investor here should have an investment horizon of at least five years as it may take some time for the fund calls to play out.

To conclude, if you are an investor who is looking for a macro-based investment strategy, then investing in a business cycle fund can be a good starting point. This will ensure that your investment is ready to tide any phase of the economy, delivering a positive investment experience.

Disclaimer

The views are personal and are not part of the Outlook Money editorial Feature.