Cyclical investing-where are we now?

Cyclical investing works if the timing is right. The key question is: "Is this the right time?" Our current expansion (begun in 2009) is getting long in the tooth. Sectors that typically lead the market later in an expansion include the capital goods sector including manufacturing stocks, basic materials including mining stocks, gold and precious metals stocks and energy stocks.

The standard definition of a passive investor is one who buys an index and holds it for the long term. For example, a Canadian passive investor might simply buy an exchange traded fund that tries to copy the S&P/TSX Composite Index and hold it for the long term.

If he does this, he accepts whatever return the market offers over the long term. He also accepts the risk that the market offers, be it volatile or tame. Passive investors accept the risk of the market in order to achieve the approximate return of the market. They also accept that the proportional weighting of a stock in the index will be the proportional weighting of the same stock in their own portfolio.

By contrast, an active investor might believe she can 'cherry-pick' a selection of stocks and trusts from the index that will move up more than the index in good times. Alternatively, if times are bad, she might try to choose a subset of stocks and trusts that will drop less.

Another way to invest actively is to rotate through the various sectors of the index as the market moves through the business cycle. Such an investor will be heavily invested in financial and utility stocks at one point of the cycle, for example, and at another stage more heavily into industrial or mining or transportation stocks.

This is called cyclical investing. The objective is to make a higher return than the overall index by being concentrated in the right spot at the right time.

Where are we now?

In many cases, trying to ballpark (let alone pinpoint) where we might be in the business cycle at any particular point in time can be a tricky business. On the other hand, right now it would be reasonable to conclude that we are in the later expansion phase of the business cycle. That's because the current expansion began in 2009, so it's been around for about eight years. Business expansions are considered to last five to 10 years, so it's reasonable to conclude this expansion is getting long in the tooth.

That might make it seem an attractive time to load up on the sectors that typically lead the market later in an expansion. Those sectors include capital goods stocks, basic materials stocks, precious metals stocks and energy stocks (see 'Stages of cyclical investing' below). Among the names on our recommended common stock list that fit the bill are Agnico Eagle Mines (TSX-AEM), Imperial Oil (TSX-IMO), Suncor Energy (TSX-SU) and Teck Resources (TSX-TECK.B).

We also note that energy and materials stocks are currently underperforming the market, contrary to what you might expect at this phase of the expansion. But such under-performance may not last if the business expansion picks up steam. Rather than heavily weighting your portfolio to these sectors, you may be better off seeking balanced exposure to the various sectors.

Stages of cyclical investing

Following are some of the typical stages of the market cycle, and the sectors that have consistently performed well during those stages:

At the bottom: The first stocks to recover from a bear market bottom tend to be financial stocks, especially the banks, consumer discretionary stocks and home improvement stocks.

As the economy expands: This is where the true cyclical stocks tend to perform best. Included are transportation stocks and technology stocks.

Later in the expansion: As the expansion further takes hold capital goods stocks, basic materials stocks, precious metals stocks and energy stocks tend to do well as scarcity of resources becomes an issue.

Early stages of a contraction: As the business cycle turns negative, staple consumer goods stocks such as food stores and beer companies, and healthcare stocks, such as pharmaceuticals, tend to outperform other sectors.

Later in the contraction: Falling interest rates tend to help interest-sensitive utility stocks and financial stocks do well.

This is an edited version of an article that was originally published for subscribers in the July 21, 2017, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

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