Stocks and the Business Cycle

Fundamentals of Market Investing by Adam J. McKee

The stock market can be divided into three major industry groups—cyclicals, defensive, and growth.  Cyclical industries’ fortunes are tied to the performance of the economy.  The cyclical industries have been further categorized depending upon when in the economic upturn they tend to perform well.  Defensive industries (not the defense industry) tend to perform well during recessions.  Growth industries are in a stage of rapid expansion, relatively independent of the economy’s strength, or lack thereof.

Cyclical stocks are closely tied to consumer demand, and they tend to be very sensitive to turns in the economy.  Consumers can react very quickly to changes in income and interest rates.  Deferring the purchase of a lawnmower or a dishwasher does not require the approval of the board of directors.  The family doesn’t need to do an extensive budgeting analysis to determine whether it makes sense.  When we need such things, we will usually just buy them (often on credit cards).

Capital goods producers, on the other hand, tend to perform strongly later in the economic cycle.  Coming out of recession, there is usually a lot of unused capacity, so manufacturers of consumer goods can initially accommodate the demand for their products without the need for additional investment.  Farther into the cycle, when consumer goods manufacturers need additional capital goods, considerable time lags often exist between the time specialized capital goods are first ordered and the time they are finally delivered.  This time lag helps to explain why capital goods manufacturers may report increased sales for some time after a downturn in the economy.

Before an increase in the economy, some sectors tend to take off; the consumer housing market is an example of such a segment.  Recession bottoms tend to carry low interest rates due to weak demand for loans since fewer businesses need financing for expansion.  Low credit demand coupled with the typical government policy of easier money at economic bottoms leads to lower interest rates, which in turn make it cheaper and easier to purchase large items such as residential housing.

An increase in housing demand has many multiplier effects—consumer credit, construction, and cyclical consumer sectors benefit from such a move.  When the housing boom incorporates many first-time homeowners, home furnishings and consumer durables manufacturers’ benefit as these new households require basic items such as furniture, stoves, and refrigerators.

Consumer staples are often referred to as consumer non-cyclicals or defensive industries.  The demand for the products of these industries tends to remain constant throughout economic cycles.  Health care providers, food producers, tobacco, and liquor producers face a consistent demand for their goods.  There are, however, other things to consider.  While consumers must purchase food during good times and bad, shifts in purchasing habits are common with changes in the economic cycle.

Consumers will probably substitute cheaper foods for higher-priced prepared foods during downturns.  General industry trends independent of the economic cycle sometimes have an overriding effect on the demand for goods.  The demand for tobacco, for example, is largely independent of the economic cycle; it is not immune, however, to changes in the lifestyle of U.S. consumers.  The movie industry used to be considered a good defensive industry.  In fact, it would often show growth during recessionary times as people substituted movie-going for more expensive forms of entertainment.

With the growth of cable TV and videotape/DVD rentals over the last decade, these newer industries have become inexpensive substitutes for the relatively high cost of movie-going today.  Utilities also perform well during downturns.  Utilities are huge borrowers of money.  The low interest rates that accompany recessions lower utility operating costs, raising profitability.  Additionally, their high dividend yields at these points will attract investors seeking both relative safety and high income.  Of course, utilities also benefit from economic upturns as demand for energy and services from industrial customers increases.

Some industries experience growth without regard to the economy.  A problem for investors is that from economic cycle to economic cycle, growth industries change.  These industries typically perform very well during recessions as investors flee companies releasing negative earnings reports and search out those firms with increasing earnings.  The biotechnology sector is still in its growth stage with expanding sales independent of the economy.

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