Trade with the equity sector’s economic cycle

BUSINESSES prosper at different times. Over the duration of a business cycle, which typically lasts for about seven years, certain businesses do well in the early period of economic expansion, some do better during mid-expansion and others prosper as economic activity begins to lessen. These fluctuations in the business activity of companies can be traded by buying stocks in “hot” sectors and selling stocks in less “hot” sectors throughout the period.

The diagram (right) illustrates when each business sector within the equity asset class is likely to outperform other sectors during the business cycle. Let’s take basic materials as an example. Basic materials such as iron ore, cement, lumber, tin and copper are all used in construction, and the period of middle expansion during a business cycle upturn is normally when construction work tends to gather pace. Then, such materials as produced by companies like Rio Tinto Zinc are in demand. So during periods of expansion companies who produce basic materials that support the construction industry tend to enjoy higher-moving share prices than utility companies, that are less likely to benefit from a boom in construction.

In a similar way, technology stocks tend to outperform at the beginning of an economic cycle as the business world starts to gear up their IT spend and upgrade their IT infrastructure as business prospects start to look brighter. Transportation companies also begin to benefit from the increased flow of business activity during early expansion, when more goods are bought by recovering companies and need to be shipped. Then, as companies start to grow their businesses during middle expansion, they require more services to manage their growth, including professional services like accountants and lawyers.

As the business cycle picks up and reaches late expansion, infrastructure spending starts to rise. Construction companies start to see increased business, and capital goods producers begin to build more components for factories to assemble. A greater demand for logistics spending leads to greater requirements for the use of iron ore, copper, zinc, aluminium, cement and other raw materials that help to build more air conditioning units, aeroplanes, factory machines and packaging materials. As the economic cycle gathers pace, the share prices of companies in the business sectors that are seeing increased demand start to appreciate relative to other sectors that are not seeing greater business activity, as investors expect higher dividend payments and stock price appreciation.

Then as business begins to tail off in the period of early contraction, spending on capital goods falls, demand for basic materials collapses and the sector rotation continues. If traders are able to time their entry and exit points carefully, they can take advantage of trading equity sectors and profit by buying stocks that are in demand and selling stocks that are not.

David James Norman is visiting professor at the Essex Business School, where he is running trader bootcamps in September and November 2011. Visit www.tradertraining.net and follow the link to Essex Business School, or contact Denise Sherer at deniseh@essex.ac.uk.