Cycle race: How sector investing can help investors navigate bull and bear markets
Your stock sector knowledge might not be a popular topic at this weekend’s dinner party, but it can be handy when you invest. Certain sectors tend to perform better or worse in certain market cycles, so understanding these cycles can help you target both sectors to invest in and sectors to avoid.
When investors discuss market cycles, the conversation turns zoological. Stocks slid into a “bear market” in 2022 as inflation spiked and Russia invaded Ukraine. In a bear market, stocks generally fall for an extended period—characterized in this instance by a 20% drop in the S&P 500 Index from its previous high.
A “bull market” is the opposite. Between 2017 and 2021, there was a long bull market with only minor disruptions. During that stretch, the S&P 500 more than doubled, helped by government stimulus, strong earnings, and historically low interest rates.
Stock cycle diversification means concentrating your portfolio in certain sectors and avoiding others based on the market cycle. Historic trends suggest some sectors perform better when the cycle is bullish, while others offer protection when the bear prowls. Though it’s tricky, seasoned investors can often tell when a cycle change is in store. The other challenging thing is knowing when to stop chasing a bull or bear.
Market cycles: Bulls vs. bears
A bull or a bear market won’t walk up and shake your hand to let you know it’s here, but you can get a sense of the market cycle by watching your portfolio and the broader market each day. Bull and bear markets are closely related to economic trends.
If a bull market has lasted a long time amid a roaring economy, signs of a change often appear. This could mean rising interest rates, inflation, or maybe a few months of poor economic data. That’s when you might consider getting exposure to “defensive” sectors, or ones that don’t tend to lose as much ground in a bear market.
If the country is in a recession and the market cycle has been bearish, you might be able to sense a bull amid rising jobs growth, company earnings, and oil prices. These often indicate better demand from companies and consumers. Then you can adjust your sector investing accordingly and pick some “cyclical” sectors, or ones that tend to rise and fall with the economy.
Defensive vs. cyclical sectors
Defensive sectors. Everyone needs to eat, stay healthy, and turn on the lights, even when the market (and the economy) is in a losing stretch. That’s why companies that make food, household products, medicine, and electricity often suffer less in a bear market, and are thought of as “defensive.” Examples include:
- Health care
- Utilities
- Consumer staples
Cyclical sectors. A booming economy that creates demand for gasoline, vacations, dining out, housing, cars, semiconductors, and construction materials tends to help “cyclicals.” Examples include:
- Energy
- Industrials
- Materials
- Real estate
- Financials
- Consumer discretionary
- Information technology
Sector investing and market cycles
A sector investing strategy is a bit more involved than popular techniques like index investing. An index investor buys a mutual fund or an exchange-traded fund (ETF) to track the performance of a major index, such as the S&P 500.
The problem with index investing: You’re a prisoner of the index and can’t use your sector knowledge to smooth out the ride during different market cycles. If you have most of your money in the S&P 500 and it has a bad year, so do you. The S&P 500 is heavily weighted toward cyclical sectors such as technology, consumer discretionary, and financials, so when the market cycle heads into bear territory, being in an S&P 500 fund means your money is like a deer in the headlights waiting to get crushed.
A sector investing strategy tries to avoid this.
Sector investing examples: COVID-19 strategy
Imagine a hypothetical investor and how they might position themselves from a sector standpoint back in March 2020 when COVID-19 hit. Major indexes rapidly declined all around the world as economies shut down, and interest rates fell sharply as central banks loosened credit conditions to encourage borrowing and spending.
Strategy one. The investor might decide on a so-called “risk-off” strategy, trying to lower their potential risk in this complex fundamental environment. One way to reduce risk would be putting money into the defensive sectors, such as utilities and consumer staples. Utilities and staples companies provide necessities like food and electricity, making them better able to weather a rough patch.
Also, in a low-interest-rate environment, where money in the bank or treasury bonds would provide little or no return, a large dividend—which many staples companies and utilities offer—looks appealing.
Strategy two. The hypothetical investor facing the pandemic might get a bit more aggressive and put money into health care, hoping it has a built-in advantage. Any COVID-19 vaccine, the investor presumes, would come out of this sector, and whichever company got it to market first would benefit. Rather than trying to zero in on a single company among many working on a vaccine, the investor buys a health care or biotech ETF, and perhaps sees benefits from the entire sector when a vaccine arrives.
Option two is more risky, and certainly could fail if a vaccine is not found quickly. Also, health care had challenges during the pandemic, with many patients putting off surgical procedures because of lockdowns. This hurt hospitals and was also bearish for medical device companies that make replacement hips and knees.
The bottom line
Sector investing isn’t something you can just jump into. But if you watch the markets for a while, cycles and sector performance start making more sense. COVID-19 and the market’s reaction to it taught even the most seasoned sector investors some new lessons.
The challenge with a sector strategy is knowing when to stop the chase. It’s easy to get carried away by gains in a bull market, but hard to take money off the table when you’re ahead. Taming your emotions is key.