Investing is ... know the cycles

Deceuninck Patrick, Columniste
20 02 2022

Obtaining and maintaining a balanced and profitable investment portfolio is not easy. After all, investing is not an exact science and is all the more human work. And when you say human work, you are undeniably thinking of its natural imperfection.

In addition, investing means taking risks. Taking risks means daring to leave the traditional safe paths. Furthermore, investing requires not only knowledge and insight, but also the ability to look ahead and have a vision. Continuous learning and discovery are the key. It is precisely this challenge that makes the man or woman great at doing his or her "thing": achieving the perfect portfolio that never loses. But is this perfection really of this world? Unfortunately, it is not! In other words, it simply comes down to tipping the balance of misses and hits in favour of the hits. When it comes to choosing the right shares individually, we know that solid company balance sheets give good profit and loss accounts, which may or may not result in a dividend.

So which method should we use? Well, it is an individual matter. But there will always be some rules and principles that apply universally. One of these rules is: know your cycles and capitalise on them. History repeats itself, doesn't it? But always in a different guise. Since the world economy is growing in the long term, we have to take calculated risks that regularly generate profits for our portfolio. In order to do this, it is important for investors to have a certain feel for the different cycles. It is a bit like nature and the four seasons.

Feeling with the different cycles.
In addition to the general macroeconomic cycle, there is such a thing as the life cycle of the sectors and the life cycle of a company. To be complete, there is also such a thing as the life cycle of a product. Everyone knows objects that we only find in museums.

The macro-economic cycle:

That the stock market moves in waves on a macroeconomic level is nothing new. One only has to look in the rear-view mirror of the stock market to know that a phase of increase (sometimes euphoria) is followed by a phase of decrease (recession). In the ultimate case, one even reaches the stage of a real depression and sometimes even a real stock market crash. That is why investors and analysts sometimes take inspiration from the findings of Kondratieff, Charles H. Dow, Ralph Nelson Elliott and even Leonardo Fibonacci da Pisa to explain and predict the cyclicality in stock market movements. To briefly explain what these gentlemen have taught us would take us too far. In any case, remember that interpreting economic cycles is a difficult exercise, not to say a perilous one. And if the above difficulty is not enough, investors must also take into account the anticipatory power of the stock markets. After all, the stock market (market cycle) is 3 to 6 months ahead of the economic cycle. This is logical, the investors of all countries try to anticipate the economic cycle. Then there is a difference between the geographical regions. The eurozone economy follows the US macroeconomic cycle with approximately 3 months delay. Or to put it in terms of weather forecasts: "When it rains in America, it drips in Europe". There is also something to say about our own country. Experience shows that given the nature of our economy (export-oriented and semi-finished products), the Belgian economy is always a few months ahead of that of the countries around us.

Link macro-economic cycle and interest rate curve.

It is one thing for investors to follow the macroeconomic cycle. But the monetary authorities do this too. They do even more: they try to steer the economy by means of the interest rate. Regularly watching the yield curve is therefore also one of the many stock market signposts. As we know, the yield curve shows us the interest rates for different maturities (ranging from less than 1 year to 30 years). This yield curve also has a kind of "cycle". Such a cycle in the yield curve (and thus the rates) can go from a "steep" curve via a "flat" to an "inverse" yield curve. Currently, we have been experiencing a phase of monetary easing (low and even negative interest rates) while inflation has been rising.

Why this digression on the yield curve? Well, investors know all too well that the interest rate is a price influencing factor in the price formation of shares. For analysts, too, the interest rate is an indispensable factor when calculating price targets for shares via their discounting models (calculating expected value in the future back to today).

Sector cycles or sector rotation.

Besides the economic evolution, we should also be aware that the different sectors behave differently depending on the macroeconomic context. Traditionally, the sectoral classification is as follows: growth sectors (e.g. high-tech); interest sensitive (e.g. banks); defensive (e.g. food); cyclical (e.g. construction) and for the fanatics there is also heavy cyclical (e.g. basic industry and raw materials). The art and the challenge is to correctly determine the weighting of each of these sectors in one's portfolio. Being invested in the right sectors (positioning) even determines the return of his invested stock market capital.

In times of recession or at the top of the economic cycle (at the first signs of weakening) defensive investing is the message. In this context, the food, distribution and pharmaceutical sectors, for example, are the least sensitive to the economic cycle.

A reduction in short-term interest rates, on the other hand, is advantageous for interest-sensitive shares. When interest rates fall, the customer receives less on his savings account while the loans taken (long-term interest rate) remain unchanged. So it is obvious that when interest rates rise, the banking sector is the first victim, followed by the utility sector.

In the event of an upturn or strong economic growth, cyclical shares (basic industry (basic chemicals, steel, raw materials) and industrial equipment) will again have the wind in their sails. In contrast, cyclical stocks underperform in an environment of slowing growth. For cyclical stocks, it is particularly difficult to determine the right entry and exit moment.

For growth stocks (telecoms, media, technology), the general rule is simple: they benefit from a rising economy. The price of these shares is profit-driven. In the valuation of growth shares, future profits are essential. As we know, downward earnings revisions and delayed growth are bad for high valuation growth stocks. And while we are on the subject of earnings, the following rules are also valid: "new" sectors have a higher average earnings growth in relation to the market; mature sectors have earnings in line with the market and sectors over the top have no or hardly any earnings growth.

Life cycle of a company

In addition to these typical general sectoral behaviours, the companies that make up the sector also have their own life cycle. With life cycle we mean here the phases: immature, growth, mature and "over the top". Roughly speaking, we can say that the automobile sector, for example, has had its glory days, but with the electrification of the vehicle fleet, it has new perspectives. Or to put it another way: "new economy" will one day become "old economy"; which does not mean that the smart older companies do not want to learn from the "new economy" and continue to reinvent themselves. The challenge is to be able to judge the management on its qualities and to assess the potential of the products or services they provide.

Technical analysis

Since we have been talking about cycles all this time, for the technical analysts among us, we should mention the phases of accumulation and distribution of individual shares (cfr Chaikin money flow indicator). Knowing which phase you are in can give you additional information on buying or selling. Know that shares sometimes go from strong to weak hands.

From a technical point of view, when studying the price charts, one can already see a bottom forming. The longer the bottom is formed, the closer the market cycle is to resumption (this is called a truism). "Solid" shares (value) at an interesting price are also a positive indicator; since the pillars of listed companies are not sinking any further.

As investors, we should always be ready for the next round. Sometimes it is a matter of patiently waiting. A correct market perception of the different cycles and their mutual mechanics can help us in this respect. Past observations are a help. An investor is like an attentive driver who regularly looks into his rear-view mirror, but above all he keeps an eye on the road ahead and stops to take a closer look at a possible opportunity. If the price is below the value, he or she naturally takes the plunge. A smart investor always has some cash in hand.

Tagged with: Cyclus.