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How to Pick Industry Sectors Based on the Business Cycle

By Jim Fink on April 26, 2010

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I’ve always considered myself a “bottom up” investor, which means that I start my search for attractive investment opportunities by analyzing individual companies, regardless of their industry sector.  I keep a list of outstanding businesses in a watch list and wait for the inevitable irrational market decline to let me buy the stock at an undervalued price.  I also like to run stock screens based on a set of fundamental and technical criteria that allows me to discover stocks that I never would have found otherwise.

Something is Missing

But, in the back of my mind, I’ve always known that something is missing in my investment process. In William O’Neil’s investment classic How to Make Money in Stocks, his research shows that three out of every four stocks follows the trend of their respective index. In other words, no matter how good one is at isolating great businesses with improving fundamentals, if its industry group is out of favor, the stock will most likely go down anyway. Similarly, David Swensen, the investment guru who runs Yale University’s $17 billion endowment, wrote in his book Pioneering Portfolio Management that a bottom-up approach is insufficient:

Asset allocation relies on a combination of top-down assessment of asset class characteristics and bottom-up evaluation of asset class opportunities.  Because bottom-up insights into investment opportunity provide information important to assessing asset class attractiveness, effective investors evaluate portfolio alternatives with simultaneous consideration of top-down and bottom-up factors.

Let’s face it, finding winning stocks that outperform the indices is a difficult process that often feels like finding a needle in a haystack. We need every possible edge available and simply analyzing individual stocks won’t get the job done.

Top-Down Analysis to the Rescue!

I think I have found an “easy button” to help me along. Specifically, a “top down” analysis, which analyzes the macro economy and business cycle, helps steers me towards those industry sectors most likely to outperform. Once I find the good sectors, then — and only then – is it time for me to focus in on individual companies.

Market Cycle Charts

All well and good, but how do you find which industry sectors perform best in each part of the business cycle?  Actually, it is pretty easy with a little Internet research. I was able to find five separate market cycle charts on the subject from the following sources: (1) stockcharts.com; (2) EquiTrend Weekly Market Watch; (3) Standard & Poor’s; (4) The Market Oracle; and (5) Jim Cramer. Although a bit different, they share similar conclusions.  The stock market anticipates the economy by a few months, so you need to differentiate between the industry and the stocks of that industry. For example:

  • Some industries are interest-rate sensitive and do best early in an economic recovery when interest rates have bottomed, so their stocks anticipate and start outperforming late in a recession (e.g., financial and utilities).
  • Others benefit from inflation and do best when the economy is peaking, so their stocks outperform starting in the middle of the economic recovery (e.g., energy, basic materials, and precious metals).
  • Technology and big-ticket consumer discretionary industries like autos and housing do best in the middle of an economic recovery when prices are still moderate yet people are employed, so these stocks outperform at the start of the economic recovery.
  • Early in a recession, consumer staples like food and healthcare do relatively well because everything else that is more economically sensitive does much worse, so these stocks outperform near the economic peak. 

Check any of the market cycle charts I link to above for more details.

Analyzing the Business Cycle With the Help of the WLI

These relationships between the business cycle and industry sectors are interesting, but this knowledge is only useful if it is possible to know where in the business cycle the economy is right now. Analyzing the business cycle is difficult! After all, there are professional economists with Ph.D’s that can’t agree where the economy is headed. 

True enough, so you just have to choose one source that you trust and go with it.  In my case, I’ve chosen to follow the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI), which forecasts cyclical turns in economic growth with an average lead time of eight months.  The ECRI was founded by Geoffrey Moore, the same man who developed the original leading economic indicators (LEI) used by the U.S. government. The WLI follows in the LEI’s footsteps but is considered a more advanced, accurate, and timely forecasting tool. Right now, the WLI just hit a 99-week high, which means that the economic recovery is going to continue full-steam ahead. According to ECRI’s managing director Lakshman Achuthan, “a double dip recession remains out of the question.” 

However, the WLI’s rate of growth has fallen to a 37-week low, so future economic growth, while positive, will not be as strong as in the recent past. Furthermore, the ECRI’s Future Inflation Gauge (FIG) has been rising continuously for a year but remains at moderate levels so inflation is not a problem.  Bottom line: continued economic growth with moderate inflation is on tap for at least the next eight months, which seems like a perfect backdrop for continued stock market gains. 

As far as choosing industry sectors, however, I still need to know where exactly in the cycle we currently are. The WLI tells me that the U.S. isn’t in recession and won’t enter one in the next eight months. But it doesn’t go much beyond that because it is designed to forecast economic cycle turns, not the length of economic expansions. So I need to do some more sleuthing.

Cruising Economic Websites and Counting the Days

My next source is economist Gary Zimmerman of the Federal Reserve Bank of San Francisco, who under the guise of “Dr. Econ” states that the average economic expansion lasts 57 months (4.75 years). Next stop, the National Bureau of Economic Research (NBER), which confirms that the recent recession began in December 2007. It refuses to declare the recession over, however, which I find ridiculous so I quickly move on to the Bureau of Economic Analysis (BEA). The BEA releases quarterly GDP figures and the latest release, pertaining to Q4 2009, shows 5.6% annualized growth.  In addition, it provides data on the GDP growth rate going back several quarters:

 

Calendar Quarter

GDP Annualized Growth Rate

Q4 2007

2.1%

Q1 2008

-0.7%

Q2 2008

1.5%

Q3 2008

-2.7%

Q4 2008

-5.4%

Q1 2009

-6.4%

Q2 2009

-0.7%

Q3 2009

2.2%

Q4 2009

5.6%

The BEA comes out with its first preliminary estimate of Q1 2010 GDP growth this coming Friday (April 30th). The Organisation of Economic Co-operation and Development (OECD) forecasts that the U.S. grew 2.4% in Q1 2010 and will grow 2.3% in Q2 2010. Based on this data, I’m willing to declare the end of Q2 2009 (June) as the beginning of the economic expansion even if NBER isn’t.  This means that we are currently 10 months into the economic recovery and have 47 months (4 years) left to go on average. This leads me to believe that the U.S. is still in the early stages of economic expansion – (10/57) = 18% into it. The stock market is at a 19-month high and has been in a bull market for about 280 trading days. According to Laszlo Birinyi,  the average bull market has lasted 1,000 trading days, so we are also in the early stages of the stock market cycle – (280/1,000) = 28% into it.

Process of Elimination

Looking at the market cycle charts, I am going to start by eliminating from contention all industry sectors that do best in recessionary conditions and stock market declines: (1) utilities, (2) financials, (3) consumer cyclical/discretionary, (4) consumer staples/healthcare, and (5) services.  I’m also going to eliminate industry sectors that do best late in bull markets: energy and precious metals. 

That leaves the following three industry sector ETFs in the sweet spot of today’s stock market and economic cycles:

  • Technology Select Sector SPDR (NYSE: XLK)
  • Industrial Select Sector SPDR (NYSE: XLI)
  • Materials Select Sector SPDR (NYSE: XLB)

Uh Oh . . .

Should you go out and buy these industry sector ETFs today? Before you do, consider a recent study entitled Sector Rotation Across the Business Cycle. It’s main conclusion:

Despite exhaustive testing, we find little support for the conventional wisdom that sector rotation across business cycles outperforms the general market.

Oh well, back to the drawing board. Unfortunately, easy buttons never seem to live up to their advanced billing.

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If you want guidance on which industry sector ETFs to buy now, don’t rely on unproven and generic market cycle charts. Instead, take Ben Shepherd’s and Yiannis Mostrous’ new investment service, Global ETF Profits, for a test drive today. Each market cycle is different and requires a fresh look. Ben and Yiannis engage in deep “top down” macro-economic analysis to find the industry sectors primed to outperform in today’s market. Try it risk free!

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Stock Talk

  1. avatar
    Mike Nelson Reply October 2, 2012 at 11:54 AM EDT

    Hi, and thank you for the article.

    I just wanted to relate how I go about finding winners and, in a backwards way, find top industry groups and finally general market direction.

    My searches consist of stocks making 52 week highs, some quarter + 30%. My greatest emphases is on price and volume action. Stocks making new 52 week highs on high volume are a buy, for me, when they break out of sound bases on high volume. On some searches I add EPS qualifications. At any rate, I look for stocks that are THE leaders right now. I feel that if I do that on a daily, or at minimum weekly basis, I stay on top of which stocks are leaders. I keep track of which industry groups current leaders belong to. This tell me three things. First, which are the leading stocks. Second, which are the leading industry groups. Third, knowing the leading industry groups gives me a clue about where we are in the general market cycle.

    I like to keep things as simple as possible and it is my opinion that by starting with current leading stocks and by keeping track of their industry groups this tells the whole story, everything I need to know.

  2. avatar
    Matt Kleman Reply March 6, 2012 at 10:48 AM EDT

    Interested in your analysis to find industry sectors primed to outperform the
    market.