Different industry groups move at different stages in the economic and market cycle. Stocks most sensitive to interest rates, such as banks and insurers, may rally early on in a bull (up) market. It’s at this point that the economy is usually struggling. Business is poor, companies aren’t expanding, demand for money is low, inflation isn’t a problem and, to get the economy moving, the Federal Reserve (Fed) is either thinking about or starting to ease credit.
Anticipating, (or discounting) such a move, investors will start to buy stocks of companies, like banks and other financial companies, whose business is the borrowing and lending of money, or whose prospects improve as rates fall. The latter include homebuilders or mortgage financiers. Utilities are also rate sensitive. They are both heavy borrowers of money to pay for plant and equipment and favorites of income-oriented investors due to their safety and high dividends.
Interest sensitive stocks, however, also can be among the first to top in the advanced stages of a bull market. By this time the economy has a full head of steam, demand for money is high, prices are usually rising and the Fed is probably contemplating a tightening of credit.
Knowing how interest sensitive stocks are dong, then, gives you a pretty good fix on where you are in the market cycle. Rate sensitive stocks are also a good leading indicator of interest.
The Defensive Industry Group includes stocks of companies whose earnings growth is steady and predictable whatever the economic conditions. Food, drug and tobacco stocks are the most common examples. Utilities fall into this category, too. Investors who are concerned that the market is starting to run into trouble, will often move out of more volatile, faster-moving stocks and into these issues.
Investors tend to buy more economically sensitive stocks as the improvement in the economy becomes obvious. These include stocks of companies that make autos, steel, chemicals, paper, and other basic materials, as well as airlines and air-freight forwarders (which heavily influence the transportation averages). These so-called cyclical stocks can do very well when the economy’s rebounding. But you have to be in them at just the right time.
Among the last industry groups to rally in a bull market are machinery manufacturers. When businesses have made so much money that they start to buy new machinery, you know it’s getting pretty late in the cycle.
Don’t confuse “cyclical” stocks with “turnaround,” plays. Turnaround companies are those that have been doing poorly for some time but which are finally getting their act together (usually under new management) by cutting staff, selling unprofitable divisions and refocusing on what they do best. About one if four big winners in the market is a turnaround play.
The Gold Industry Group tends to rise when the stock market has fallen and to decline during periods of broadly rising stock prices. As such, they can be sound investments during bear (down) markets. They aren’t counter-cyclical all the time, just most of the time. So if you’re invested in other stocks, a significant rally in the gold index is a worrisome sign.
As you can see a keen eye on the different industry groups can give great insight into the stages of an economic cycle. While aberrations do occur, over the long-term, the direction of the stock prices of differing industry groups will be followed by a fundamental change in the underlying business of those groups.
Quote of the Week: “The man who dies rich dies disgraced.” — Andrew Carnegie
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.