How to use stages of business cycle for your investment decision

It is a well-established fact that the share price of the company is largely determined by its financial performance and how is it valued by investors. Nevertheless, the performance of the companies in many cases is dependent upon how the economy is performing and their fate is closely tied with the economy. This does not mean that all the stocks and the companies behave in the same way while the economy is going through different phases of the business cycle.

The rule of thumb is that as the economy declines, it will adversely impact the entire stock market irrespective of the sector they come from with few exceptions. Moreover, it has been observed that the stock market acts as a leading indicator of the economic cycle. According to the data compiled by Jeremy Siegel, during the 42 recessions that have occurred since 1802, 39 were preceded by stock market declines of at least 8 per cent. What this means is that stocks fall prior to the recession.

For an active mutual fund investor, it gives an indication when to allocate what percentage of assets to equity and debt. So, when an economic downturn begins, it is prudent to switch from equity to debt and when the economy shows signs of improvement you can once again invest in equity. The only problem with this strategy is that many a times stock market gives a false indication of a reversal in the economic cycle. According to a research, if you would have followed this strategy of switching your investment between equity and debt based on economic cycle, it would not generate a superior return over ‘buy and hold’ strategy. It is difficult to even for an astute economist to pinpoint the reversal of economic cycle, let alone an individual investor.

This does not mean that the economic cycle cannot be used by investors to make their investment decision. While stocks do move in advance of the economy, specific sectors have different relative performance throughout the economic cycle. Therefore, you can employ the sector rotation strategy to position your investment.

Currently, the economy is going through the moderate expansion stage, characterised by moderate inflation, moderate interest rate and moderate unused capacity. Historically, it has been seen that in this stage, sectors that do well are basic materials companies, chemicals, plastics and paper. Therefore, remain invested in equity and look for funds that have a higher concentration of shares from these companies.