As the year changes and the earth's axis tilts, weather, music, and investors' portfolios all change.
Just like how summer turns to fall and the leaves disappear, so will your portfolio’s gains if you don’t rotate your holdings to rebalance them.
During an economic downturn, such as the current coronavirus pandemic related one that has caused persistently elevated unemployment, certain industries perform better than others during different stages of the economic cycle.
And while an economic collapse due to an extreme shock to demand is unprecedented to say the least, it hasn’t resulted in too much deviation from who the winners are during the earlier stages of the economic cycle.
The Economic Cycle:
- Recession
- Early Recovery
- Late Recovery
- Early Recession
Investing’s sector rotation theory comes from an analysis of data published by the National Bureau of Economic Research (NBER). This data showed that certain sectors of the economy outperformed during certain stages of the economic cycle.
The first stage of the economic cycle, Recession, is when the house of cards goes tumbling down. The stock market crashes, people lose their jobs by the millions, GDP declines for at least two quarters. Tech stocks tend to do well during this phase, with industrials starting to pick up near the end.
During our next stage, the early recovery, consumer sentiment begins to improve, some jobs start slowly coming back, GDP starts falling slower and might even increase, while the Treasury yield curve steepens. Industrials continue to do well here, especially in the early parts of this stage, with basic materials and energy stocks outperforming throughout as economic activity picks back up.
The late recovery stage is when markets are starting to see decreasing growth on the margin, meaning the yield curve is flattening and interest rates are rising. Traditionally, energy stocks outperform here at the beginning, consumer staples and services start to get back in full swing during this stage.
Finally, the early recession stage is when consumer sentiment starts to decline, production slows and interest rates peak. This is the preamble to the next crash and utilities and cyclicals tend to do well here.
The Current Economic Stage
Barring vaccine-proof variants that reinstate lockdowns, our current recovery could be seen somewhere near the end of the first stage, or perhaps even at the beginning of the early recovery stage. This is evidenced by the frequent talk of the “reflation trade” from analysts, as well as by who is beating the S&P and who isn’t.
During these last three months, the S&P 500 has increased 9.31%. The highest performing sector during that period was the Energy sector at 23.41%. If you recall, oil futures traded in negative territory, with traders getting paid to take oil just over a year ago. Next up is Financials at 18.74%, which is certainly a welcome sign of recovery as the banks do the lending which funds the projects that grow the economy. Next we have strong performances from Industrials, Communication Services, and Real Estate who are all slightly above 14% gains during the same period.
Bringing up the rear are Healthcare with 2.7% growth, Consumer Staples with 2.95% growth, Utilities at 6.31%, and the Covid-darling Tech stocks with 6.75% growth. The Healthcare stocks are underperforming as the winners from the coronavirus have all but been decided, as vaccines are - despite a possible fourth wave of infections - making a difference and the average hospital stay for severe cases is falling as better treatment has been discovered.
Consumer Staples also comes as no surprise since the industry includes your household goods. These stocks certainly got a demand boost as we all transitioned to working from home, but are sure to see that demand retreat as people get back out. Lastly, tech, though experiencing a rally during this past month (+6.93%), which is likely largely due to increased spending due to economic stimulus payments, the sector is slowly transitioning from being so heavily relied upon for day-to-day living.
So, right now, we are clearly in full-on reflation mode. The stocks that need a growing economy are coming to the forefront as the previously relied upon stocks are slowly falling back to earth.
Looking Forward
An always important thing to keep in mind in investing is that markets are forward looking. This means that the stocks that are good today are the ones we expect to report good numbers tomorrow. Stocks that rally are those that we - the market as a whole - expect to do grow relatively faster than others.
The coronavirus brought on an unprecedented demand shock, which is not expected to last once the economy fully reopens. Though it may not be quite as romantic or robust as the former President led people to believe during debates, there is a degree of truth behind the notion that, when the economy opens up, people will go out and spend again and the economy will grow pretty rapidly, at least at first.
Unlike during the Great Recession which was caused by the housing market collapsing and came with slow economic growth for years, we can expect a faster paced recovery. Especially with robust economic stimulus that has played its part in keeping the economy afloat, even if progress in Congress has been slower than many would like.
When thinking about what stocks will be best in the next part of the cycle, it’s important to remember just how unique this economic downturn is when compared its predecessors.
Consumer staples tend to do well in the late recovery stage, but when you consider that consumer staples had such a strong boost to demand from lockdowns, it might not be that way this time around. The sector is currently underperforming in or around stage two, so come the next stage, it might outperform a bit, but it likely won’t be as robust a rally as in previous recessions.
Another sector that may have a similar fate is energy. These stocks bore the brunt of the demand shock, which may put it in a similar position as the sector is currently rallying strongly during stages one and two. As we enter stage three, it’ll likely slow as travel will have returned (as much as it will, as some travel such as business travel may never return in full force). However, unlike consumer staples, these stocks might actually underperform or just drag sideways when, historically speaking, the sector supposed to be rallying at full force.
As you rebalance your portfolio for this stage, remember to rely on historical data less so than you may have during other downturns. Regardless of the letter of the recovery - U-shaped, V-shaped, whatever - we are in uncharted territory so the best thing to do is to remain on your toes ready to pounce at the next opportunity when the time comes.
