On any given day, stock prices move so quickly that it is impossible for any single person to understand why. However, over a longer periods, stock market patterns emerge. In general, the market cycle begins from a market bottom after which stock prices rally during a bull market. Eventually, market prices hit a peak and stock prices begin to fall which causes a bear market. Though the market as a whole follows this pattern, sector performance varies relative to the market at different points in the cycle.
Stock market sectors don’t follow market performance because certain sectors profit more during certain stages of the economic cycle. Investors who want to use sector based goals need to have an in depth understanding of sector performance relative to the economic cycle, so that they can make informed investing decisions that will help them meet their goals.
How does sector performance relate to the economic cycle?
According to the National Bureau of Economic Research, the economy, like the stock market, moves in four stages. The four stages of an economic cycle include the following:
- Full Recession (Falling GDP and low consumer Demand)
- Early Recovery (Rising GDP and high demand)
- Late Recovery (Slowing GDP growth and slowing demand growth)
- Early Recession (Stagnant GDP and falling demand).
During different economic phases, different sectors outperform the other sectors and the market as a whole based on anticipated profitability during the economic stage.
Sam Strovall of Standard and Poor’s compared each sector’s performance to the stock market and the total economy to demonstrate which sector tends to outperform during each phase of the economic cycle and the market cycle.Most of these trends make sense. For example, basic materials and industrials outperform during the early recovery phase of the economic cycle since during this phase many companies increase investment and output to keep pace with rising consumer demand. Likewise, utilities, consumer defensive (staples), and healthcare outperform during the early recession phase since companies that provide these services tend to forecast stable profits despite falling consumer demand.
It’s important to note that not every sector has strong of correlations to the phase of the economic cycle, and historical performance does not predict future performance. Still, investors with a sector based strategy must understand the relationship between sector performance and the economic cycle to make informed investment decisions.
Why does the sector benchmark matter?
Investors with sector based strategies need to understand sector benchmarks. Many DIY investors gauge their performance using the S&P 500, but investors need to understand their sector benchmark too. At DIY.Fund, we use the Sector SPDR ETFs as sector benchmarks.
Since certain sectors run counter-cyclical to the market as a whole, an investor may see that they are under or over performing the market, but this may not help them determine if they have appropriate investments. Seeing performance relative to a sector benchmark helps investors understand if they are meeting their investing goals, and highlights strengths and weaknesses otherwise hidden from the average investor.
Over the long run, DIY investors can use sector analysis to help them make better investing decisions and manage their portfolio more like a professional.