Economic Cycle and Sector Rotation

The economic cycle is an important concept to understand when investing in stocks.  It is helpful to know where the overall economy is sitting in order to see what sectors of stocks might be under performing or over performing the S&P benchmark.  It also helps in forming an overall market posture and get prepared for a bear market and/or get back in at the beginning of a bull market.  The younger a person is doing long term investing the less this needs to be a focus.  However, once a person gets 10 to 15 years from retirement this knowledge can become critical in maintaining a nest egg that has been building.  Since an economic cycle can take 7 to 10 years to play out, as you get nearing retirement and can see that a late expansion situation exists, like the one I think we are currently in, then one should pay attention to how aggressive they have allocated their 401K or IRA and take steps to become less aggressive by transferring into safer funds etc.

 

 

Last 6 months sector performance as of June 21, 2016

Last 3 months sector performance as of June 21, 2016

These sectors will never follow a “textbook” looking scenario so one has to make judgements on what you see.  In the 6 month performance even though Utilities (late expansion) show strength, Energy, Materials and Consumer Staples are prominent indicating late expansion to early contraction.  Then in the 3 month performance Utilities has slipped but late expansion to early contraction continue to outperform SPY (S&P benchmark).  This is why I think we are currently in late expansion.  The market has been moving sideways for sometime now and as it moves sideways money has been leaving consumer discretionary and technology sectors and moving into safer consumer staples, energy and utilities.  With the market stalled right now, growth stocks are not getting the fuel they need to drive prices up.  While it might take another year to enter contraction, I think the threat is real because it is the normal flow of the economic cycle.  Below is an explanation of the economic cycle and business cycle and what to look at to help determine where we are.  Hint, the GDP report is very important.

What is the 'Economic Cycle'

The economic cycle is the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (GDP), interest rates, levels of employment and consumer spending can help to determine the current stage of the economic cycle.

BREAKING DOWN 'Economic Cycle'

An economy is deemed to be in the expansion stage of the economic cycle when gross domestic product (GDP) is rapidly increasing. During times of expansion, investors seek to purchase companies in technology, capital goods and basic energy. During times of contraction, investors will look to purchase companies such as utilities, financials and healthcare .

What is the 'Business Cycle'

The business cycle is the fluctuation in economic activity that an economy experiences over a period of time. A business cycle is basically defined in terms of periods of expansion or recession. During expansions, the economy is growing in real terms (i.e. excluding inflation), as evidenced by increases in indicators like employment, industrial production, sales and personal incomes. During recessions, the economy is contracting, as measured by decreases in the above indicators. Expansion is measured from the trough (or bottom) of the previous business cycle to the peak of the current cycle, while recession is measured from the peak to the trough. In the United States, the National Bureau of Economic Research (NBER) determines the official dates for business cycles.

BREAKING DOWN 'Business Cycle'

According to the NBER, there have been 11 business cycles from 1945 to 2009, with the average length of a cycle lasting about 69 months, or a little less than six years. The average expansion during this period has lasted 58.4 months, while the average contraction has lasted only 11.1 months.

The business cycle can be effectively used to position one’s investment portfolio. For instance, during the early expansion phase, cyclical stocks in sectors such as commodities and technology tend to outperform. In the recession period, the defensive groups like health care, consumer staples and utilities outperform because of their stable cash flows and dividend yields.

As of January 2014, the last expansion was determined to have commenced in June 2009, the period when the Great Recession of 2007-09 reached its trough (technically, that recession began in December 2007).

Expansion is the default mode of the economy, with recessions being much shorter and less common. So why do recessions occur at all? While economists’ views differ on this subject, there is a clear pattern of excessive speculative activity evident in the latter stages of expansion in many business cycles. The 2001 recession was preceded by an absolute mania in dot-com and technology stocks, while the 2007-09 recession followed a period of unprecedented speculation in the U.S. housing market.

The average length of an expansion has increased significantly since the 1990s. The three business cycles from July 1990 to June 2009 had an average expansion phase of 95 months – or almost 8 years – compared with the average recession length of 11 months over this period. While some economists were hopeful that this development marked the end of the business cycle, the 2007-09 put paid to those hopes.

Recessions can extract a tremendous toll on stock markets. Most major equity indexes around the world endured declines of over 50% in the 18-month period of the Great Recession, which was the worst global contraction since the 1930s Depression. Global equities also underwent a significant correction in the 2001 recession, with the Nasdaq Composite among the worst-hit as it plunged almost 80% from its 2001 peak to 2002 low.

What does 'Expansion' mean

Expansion is the phase of the business cycle when the economy moves from a trough to a peak. It is a period when the level of business activity surges and gross domestic product (GDP) expands until it reaches a peak. A period of expansion is also known as an economic recovery.

BREAKING DOWN 'Expansion'

An expansion is one of two basic business cycle phases; the other is contraction. The transition from expansion to contraction is a peak, and the changeover from contraction to expansion is a trough. Expansions last on average about three to four years, but they have been known to last anywhere from 12 months to more than 10 years. Much of the 1960s was a time of expansion, which lasted almost nine years.

Economists and policy makers closely study business cycles. Learning about economic expansion and contraction patterns of the past can help forecast potential trends in the future. Whether cash is available or scarce, interest rates are low or high, and companies and consumers can borrow money to spend on goods and services affects how businesses and consumers react.

What is a 'Contraction'

A contraction is a phase of the business cycle in which the economy as a whole is in decline. More specifically, contraction occurs after the business cycle peaks, but before it becomes a trough. According to most economists, a contraction is said to occur when a country's real GDP has declined for two or more consecutive quarters.

BREAKING DOWN 'Contraction'

For most people, a contraction in the economy can be source of economic hardship; as the economy plunges into a contraction, people start losing their jobs. While no economic contraction lasts forever, it is very difficult to assess just how long a downtrend will continue before it reverses because history has shown that a contraction can last for many years (such as during the Great Depression).

Examples of Expansion and Contraction

Expansion, or a boom, occurs when the Federal Reserve lowers interest rates and buys back bonds in the open market to add money to the financial system. The bondholders put their cash in the bank, which lends out money to companies that purchase buildings and equipment and hire workers. The employees produce more products and services to meet consumer demand as the economy improves. Unemployment is low while productivity and consumer spending are high. Money flows freely through the economy.

When the economy contracts, or busts, productivity declines, business revenues go down and companies lay off workers to decrease expenses. Unemployment rises, and consumers spend less. When the GDP declines over two consecutive quarters, a recession occurs. When productivity and revenue slowly begin increasing, economic recovery begins. The unemployment rate decreases as consumers spend more and the economy begins expanding.

Since 1945, the U.S. economy has gone through 10 expansion and contraction phases. Expansion periods included 1975 to 1980 and 106 months in the 1960s. Durable manufactured goods were more affected than services, as were wholesale and industrial prices more than retail prices.

Leading indicators such as average weekly hours worked by manufacturing employees, unemployment claims, new orders for consumer goods and building permits all give clues as to whether an expansion or contraction is occurring in the near future. While not completely accurate, knowledge about a certain industry or company can help prepare for changes in the economy before they occur.

http://www.investopedia.com/terms/e/economic-cycle.asp

Manage Risk with Position Sizing

Position sizing should be part of your overall investment strategy regardless of what style of investing you use.  It is intended to control downside risk.  There are certain rules you should follow but like most things with stock investing you do have to customize the process to fit your personal needs and risk profile..

How much you buy in a single trade—or your position size—is a critical decision. It directly impacts how much you might gain or lose on a trade and is another key part of the risk equation. Position size is influenced by two important concepts: portfolio risk and total amount invested.

Portfolio risk is the target maximum amount of money you’d lose on a single trade if the trade hit your stop, or was “stopped out.”  Most investors with a “Low” appetite for risk should settle in on .5%, moderate risk 1% and aggressive should keep it 2% or less.  If you are just getting started with investing I’d recommend the 1/2 percent level until you get familiar with how the sizing works and impacts your overall portfolio.

Investors also need to consider the total amount invested in any one trade. Consider setting a guideline to allocate no more than 10% of your portfolio to one investment. You may want to scale down if you’re more conservative or new to investing.

To figure this all out you need to determine the Trade Risk of the stock you are ready to purchase.  Trade risk is the stocks purchase price minus the stop price.

Stop Price has no right or wrong answer when calculating.  It is your decision to make at the time of the purchase when you get out of a stock that is turning against you.  One good method is to look at current support levels on the chart and set a stop price.  (Low risk appetite set just below support, average risk about 3% below that and more aggressive set about 5% below support. 

Here’s an example of a stock XYZ selling for 55.69. 

Some might see support at 53 while others may call support at 50.50.  Neither is wrong and will end up carrying the same risk in dollars.  The trade risk on the 53 stop is 55.69-53=2.69  while the trade risk on the 50.50 stop is 55.69-50.50=5.19

In the below example, notice that the acceptable risk per transaction is 1000 dollars so with the tighter stop you can purchase 371 shares but need to get out if stock goes down to 53.  Also notice that since you don’t want to exceed 10 percent of the portfolio you need to reduce your purchase from 371 down to 179 to stay under 10,000 dollars.  This also reduces your risk exposure down to 481 dollars if you have to exit at 53.

Higher trade risk below equals less shares per max risk (192 vs 371 above) but shares to actually buy remains the same at 179 due to 10% allocation rule.

Lastly, Here is a google spreadsheet for you to use to make your own calculations if you decide you like this concept and want to incorporate it into your trading rules.

Google Sheets Position Sizing Calculator

I did put edit rights on this share but if you plan to use it you should save a copy of it to your google sheets for your personal use.

Investment Risks–Let me count the ways

When I first started investing I was well aware that there were risks involved but I had the most basic idea that risk was simply the threat of stock going lower then what you paid for it thus creating a loss.  I had no real idea of how varied risks were and how to manage it.  Because of that lack of knowledge, my first year had mixed results and thankfully were not totally devastating but did keep my overall returns flat because I did not know how to manage the stocks that were falling.  When I delved into the subject of investment risks I learned just how many types of risks were present. 

There is two categories of risk, unsystematic and systematic.  Unsystematic risks can be lessened through diversification of the portfolio as opposed to systematic risks that do not respond to diversification.

Examples of unsystematic risks are:

Business/Financial Risk:  This risk is specific to a company or industry.  Company profits can change based on management decisions or industry trends.  Financial risk comes into play when companies take on to much debt and management perceptions of the company’s ability to repay is misjudged. 

Event Risk.  This risk is caused by an unforeseen event that impacts the company’s finances like tax law changes or regulation changes.  Also lower then expected quarterly earnings and revenue surprises are event risks.

Political Risk.  This risk primarily applies to forgein stocks where changes in political and economic climates are not stable

Liquidity Risk. This is the risk of not being able to sell an asset quickly near or at the market price.  U.S. stocks are considered the most liquid but even in the U.S. volume levels must be considered for quick exits.

Examples of systematic risks are

Inflation Risk.  This risk applies primarily to bond, CD’s and other fixed income type investments.  Erodes your buying power if inflation exceeds returns set on the fixed income instruments.

Reinvestment Risk.  This is the opposite of the inflation risk.  If interest rates are falling when fixed income assets and are to be re-invested, the rate of return will be less then desirable.

Exchange Rate Risk.  This risk applies mostly to forgein stocks.  Currency exchange rates are constantly changing so you could be buying on a strong dollar and selling on a weak dollar which impacts how much you get in U.S. dollars.

Market Risk.  This risk affects all types of securities and most often is driven by changes in the economy.

Understanding these risks are important considerations as one evaluates where to allocate what percentage of what assets in the overall portfolio.  How much in stocks?  How much in bonds/fixed assets?  In the stock portion, how much in income versus how much in growth stocks?  In the bod portion, how much in long term versus short term?  Then, in stock selection, how much do I risk in each stock?  How do I manage that risk?

When I said above that my idea of risk was the risk of the price of my stock going down, while accurate, certainly fell way short of the actual risks.  As I learned about these risks over the next 3 years of my vast experience, I have made several adjustments to my investment methods to mitigate the risks so I am not as exposed as I was.  But, let there be no mistake, as much as you learn about risk you cannot eliminate it if you seek to be successful in your investments. 

Differing Outlooks on the Market

Below are excerpts from an article on Seeking Alpha from a poster known as “Chowder”.  It matches a lot of what I use to try and keep my investment choices in perspective since my personal allocation is based on differing time frames.  The dividend portion of my portfolio is 10 plus years and I have taken into consideration his comments below about which ones to invest in. 

Excerpts from:  http://seekingalpha.com/article/3244406-differing-outlooks-on-the-market

Many individuals, when faced with a simplistic analysis of the markets, tend to lean towards the belief that everyone in that market is thinking and acting as one, with common beliefs in terms of future price movement. Needless to say, things are not as simple as they appear.

The market is a battlefield where very different groups of individuals and institutions collide. Each one of these actors will bring with themselves very diverse outlooks on the market, trading or investing it within different time frames, often with very different goals and objectives, and thus, with oftentimes opposing views. Day traders, swing traders, core traders, hedge funds, mutual funds, ETFs, short-traders, individual investors, banks, insurance companies and others won't necessarily share the same investing ideas in terms of the amount of time they plan to hold their positions, or even the direction the market is bound to take.

This doesn't mean that the different groups can't profit from the market at the same time, it's that the different time frames and various goals and objectives will inspire them to manage their portfolio's differently.

Stick to trading or investing in the timeframe your plan calls for, sticking with the relative points of your business plan. If the plan calls for buying high quality companies at a 10% discount to fair value, and the opportunity presents itself, don't let market conditions or others talk you out of it. You've planned your work, now work your plan, always keeping your time frame in consideration. Different time frames require different tactics. Know yours!

Don't allow others to distract you, or tell you your goals are meaningless, or try to place obstacles in your way.

Obstacles are those frightful things you see when you take your eyes off your goal. --Henry Ford

Over the years, I have found that the best approach to investing in companies is to be sure you have the full faith and confidence that the investment will rise. If you do not, then during the tough times you may force yourself to sell. Any investment that offers a threat to long-term confidence, that may be appealing to sell at the bottom, rather than appealing to buy at the bottom, is not the right long-term investment. The right long-term investment will be, ironically enough, one that becomes more attractive to you as it declines. The opportunity to add more to your investment becomes as attractive as the actual gains you are seeking. From a psychological standpoint this will always be the best investment or investment strategy, because a strong holder and one who can buy declines will always stand a better chance of success than one whose investment life is governed by the fear of loss.

Put another way, a good investment is one in which paper losses are tolerable.

According to Lowell Miller, the author of The Single Best Investment , the best long-term investment is one that is easy to hold, and easy to buy in moments of decline. The best long-term investment has something about it which builds confidence in the long-term future - even though the current moment may include aspects that have frightened other investors.

We don't need to get more than we need in an investment! We don't need to strive for maximum return or shoot for the biggest number. The best long-term investment is one in which we can achieve reasonable long-term goals. Reasonable goals are attainable. Fantasies are not.