Investing considerations for late market economic cycles

The bull market may be in its late cycle, so what should thoughtful investors consider for their portfolios?

Economies and markets are cyclical. Sometimes the cycle lasts for nearly a decade, while other times it may take only a few years for the cycle to complete. Investors often will pay attention to signs indicating that the markets and economy are in certain stages of the cycle. This way they are prepared to make changes to their portfolio to help weather any volatility that may occur.

Generally speaking, the early cycle is when the economy transitions from recession to recovery. Mid-cycle is when the recovery picks up speed and breadth. In the late cycle, growth slows and cracks start to appear. Then growth sputters out, the economy shifts into reverse, the markets go into a new recession and start a new growth cycle all over again.

History rhymes

No two cycles or markets are the same. Remember the saying “history doesn’t repeat itself, but it rhymes?” For investors, those rhymes are important because they may reflect fundamental characteristics of our economy and financial system.

One characteristic is capacity utilization. For example, a manufacturing company has the capacity to produce cars or turbines at a certain maximum rate. When orders are flooding in, the company produces near that rate, and capacity utilization is high. When orders are low or cancelled, the company produces at a fraction of that rate, and capacity utilization is low.

Another characteristic is the Federal Reserve (“Fed”) policy. During the early cycle, when the economy is in recession, the Fed loosens monetary policy via a lower Fed funds rate. During the late cycle, monetary policy tightens.

Look for rhyming, not exact repetition. Companies can increase capacity through capital investment, contract manufacturers and changing products. The Federal Reserve can loosen and tighten monetary policy by buying and selling bonds (quantitative easing). During the recessions of the 1970s, high inflation forced the Fed to raise interest rates rather than lower them. One thing that doesn’t change is the business cycle. We haven’t found a way to possess an economy that grows non-stop forever.

Signs we may be in the late cycle

The U.S. economy is now in the eighth year of recovery since the 2008-2009 recession. The U.S. stock market is in the second longest bull market since the 1950s. Only the 1990-2000 bull market lasted longer than this one. Timing suggests we may be in the late part of this cycle.

Late cycles tend to be characterized by some common developments. For example, corporate revenue growth declines; profit margins peak and begin to roll over; wages rise; the economy approaches peak employment; banks tighten lending standards; the Federal Reserve tightens monetary policy; the yield curve flattens; new manufacturing orders peak; and capital investment peaks. Some of these late-cycle signs can be evidenced today.

Investing in late-cycle markets

In late-cycle markets, investors may be rewarded by following a disciplined investment strategy, which may include the following:

Consider high-quality companies with secular growth and higher margins. In the late cycle, growth becomes scarce and profits are pressured. Weak companies may run out of time to improve their growth or expand their margins.

Consider companies with less economically sensitive revenue. Companies dependent on discretionary spending tend to be at greater risk from spending slowdowns and budget freezes in the late cycle.

Consider lower-beta, lower-volatility stocks. Broadly speaking, “beta” describes how much a stock’s price reacts to market moves. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Low beta stocks move less than the market and tend to be less volatile when markets swing.

Consider defensive industries. More defensive industries – such as household products, commercial services, utilities, software and pharmaceuticals – deserve a second look because consumer demand for these products and services is usually less affected as the economy slows.

Consider larger capitalization, higher quality stocks with strong balance sheets. Small cap, low quality, and debt-burdened companies frequently carry increased risks, such as greater price volatility in the late cycle. Dividend growth stocks deserve extra consideration, but distinguish those from stocks where rising dividend yields are due to falling stock prices.

Consider higher credit quality bonds. Investing in fixed income securities (debt securities) are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower rated and non-rated securities present a greater risk of loss to principal and interest than higher rated securities, and can act like cyclical or lower-quality stocks. Credit risk deserves extra attention in the late cycle.

Moderate your return expectations. In late cycle markets, focus on moderate gains and capital protection. When appropriate, consider hedged investments and higher cash levels. The late cycle is not the time to take excessive risks chasing double-digit returns.

Diversify and rebalance portfolios. Diversification is always important, but especially in late-cycle markets when risks may be rising and markets are alert to signs of the next contractionary stage of the business cycle. After a long bull market in stocks, many portfolios are aggressively positioned with overweight positions in stocks and underweight positions in quality bonds. Consider reviewing and rebalancing your portfolio with assistance from your investment professional.

Consider active investment strategies. A bull market may reward index funds. In late-cycle markets, it is important to be more selective in your security selection. Stock index funds typically hold stocks in proportion to the market value of equity, rather than defensiveness, balance sheet strength or secular growth. Bond index funds are often weighted by the market value of bonds outstanding, meaning that the most indebted companies may have the largest weighting.

Is it different this time?

Markets always tempt us with the promise that it will be different this time. Some promises that exist today include revolutionary technology, tax cuts and regulatory reforms. Remain thoughtful, yet skeptical. Expansion and contraction cycles are inherent in our economy, and expansions don’t last forever.

John Liu is a senior portfolio manager with Private Wealth Management at U.S. Bank. You can follow him on LinkedIn at www.linkedin.com/in/johnyaoliu.

The information provided represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific investment advice and should not be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation.

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