The economy goes through cycles. It expands for a few years, then contracts and again expands. If we look historically, different sectors tend to perform during different stages of an economic cycle.
The economy goes through cycles. It expands for a few years, then contracts and again expands. If we look historically, different sectors tend to perform during different stages of an economic cycle. So, if a sector is being shunned right now, do not think that investment in those sectors is a bad investment. Sector rotation and the economic cycle have been explained beautifully by Sam Stovall’s S&P Guide to Sector Rotation. He states that different sectors are stronger at different points in the economic cycle. Basically, there are four stages of the economic cycle—early recovery, full recovery, early recession and full recession. Various studies have shown that stock markets are leading indicators on the business cycle. Various economic indicators such as industrial production, interest rates and yield curve indicate the direction where the economy is heading.
Indian economy in early recovery stage
The Indian economy is in early recovery stage where consumer demand and industrial production is beginning to improve. In full recovery, manufacturers undertake capital expenditure to expand production. Inventories are low, inflation is high and commodity sector and energy sector perform well. In an early recession, demand declines and industrial production follows suit. Interest rates are at peak and sectors which perform well are utilities and late stage cyclical like financial and consumer goods. In full recession, unemployment is high and central banks beings to cut rate. In this stage, investors turn to defensive sectors such as fast moving consumer goods and pharmaceuticals.
According to Sam Stovall’s theory, before recovery when economic data start to pick up, the sectors which start forming a base are cyclical like automobiles and housing. Those sectors go through the phase of accumulation and favourable price actions are seen. If we look at the year 2017, world recovery was being witnessed.
Higher than consensus of economic announcement leads to rise in yields and fall in bond prices. During this period, commodities start to rise; there is rise in cyclical sectors like bank, automobile, capital goods, metals and oil and gas and fall in defensive sectors like information technology, pharmaceuticals, consumer non durable and fast moving consumer goods. This was what happened in the year 2017. Lower than expected economic data can lead to rise in bond prices and fall in yields. Also, fall in commodity prices is seen along with fall in cyclical sectors and rise in defensive sectors.
Markets are fickle
Markets are fickle and loyalties change. In fact, during 1995-2001, information technology was the darling of investors, but in 2001-2007 the sector sharply underperformed. The sectors which were shunned during 1995-2001 such as capital goods and banks gave significant return during 2001-2007.
Pharmaceuticals, which saw good returns between 2008 and 2015, underperformed in the last two years. It is evident that sectors which were popular at one time got a cold shoulder from market while untouchable sectors became market darlings for investors. So, investors who have invested in state-owned banks and telecommunication companies may feel at present that the future is bleak.
But what history has taught is that there is no sector which remains untouchable forever and no sector that is a constant investors’ darling. Sector rotation happens and we need to identify the current economic cycle and move our money accordingly to those sectors which perform during the given economic cycle.
By Dhruv Desai
The writer is director & COO, Tradebulls Securities