Knowing which sectors can perform better in the stock market is possible if you observe the phases of the business cycle. Take a look at some of the basics of mutual funds, and then move on to learning more about investing with sectors.
Begin by Building a Smart Portfolio
Timing the market by investing in sector funds may sound risky on the surface, but it can be done wisely. Begin to build the best portfolio of funds with an asset allocation that fits your time horizon and your level of risk tolerance. Investors who may need to tap into their savings in less than 10 years should have a somewhat conservative mix of stocks, bonds, and cash, compared to an investor with more than 10 years to invest. You’re ready to build your portfolio when you arrive at an asset allocation. One good model to follow is the “core and satellite structure.” As the name suggests, you begin with a “core,” such as one of the best S&P 500 Index funds, and then build around it with other funds. Sectors can be some of the “satellites” that become a portion of your portfolio.
Investing With Sector Funds
Sector funds focus on a certain industry, social goal, or sector, such as healthcare, real estate, or technology. Their goal is to provide focused exposure to specific industry groups, called “sectors.” You can use sector funds to increase exposure to certain industry sectors that you believe will perform better than others. How can you know which sector will perform best at any given time? There’s no crystal ball to give you the answer. No one knows for sure what the stock market or the economy will do, especially over short time-spans, such as one day, one month, or even one year.
How the Stock Market Relates to Cycles
Knowing the difference between market and economic cycles and how they’re related to performance can help you pin down the best timing and portfolio structure. A bull market for stocks often peaks and can begin declining before the economy peaks. A bear market or stocks often comes on suddenly, though the conditions for it develop slowly. As the bear market develops, active managers will reallocate to safer sectors, but long-term investors may prepare to watch for upcoming bargains if prices fall sharply. By the time the Federal Reserve announces that a recession has begun, the biggest price drops may have already happened. All traders, asset managers, pension funds, banks, and insurance companies make up and affect what most people refer to as “the market.” But the market refers to the capital market, which is a marketplace to buy and sell securities, such as stocks, bonds, and mutual funds. When you hear or read about “the economy,” it most often refers to what makes up an economic system. It includes consumers, industries, corporations, financial institutions, and the government.
Choosing the Best Sectors Based on Cycle Phases
Business is the place where the stock market and economy overlap. Small business owners and corporations drive the economy. They’re the reason the stock market exists.
Early-Cycle Phase
The economy is quickly coming back from recession in this phase. Credit markets begin to grow again as monetary policy is still easing. Interest rates are falling, which adds money and liquidity to an economy weakened by the recession phase. Corporate earnings grow. People spend as a result. The best sectors during this phase include consumer cyclicals and financials. Bonds can also be good, because bond prices tend to rise as rates fall.
Mid-Cycle Phase
The mid-cycle phase tends to be the longest of the cycle. The economy is stronger, but growth is moderating. Interest rates are at their lowest, and corporate earnings are at their strongest of the cycle. The best sectors here include industrials, information technology, and basic materials. Interest rates are moderating and perhaps starting to rise as the Fed tries to fight off inflation.
Late-Cycle Phase
Growth is slowing and begins to appear overheated in this phase as inflation climbs higher, and stock prices begin to look high compared to earnings. The best sectors in this phase include energy, utilities, healthcare, and consumer staples.
Recession Phase
Economic activity and corporate profits are falling. The stock market may have entered a major correction by this point. Interest rates are at peak levels. The best sectors in this phase include the same sectors that began to gain favor in the late-cycle phase. But this phase is the shortest, often less than a year. Moving into early-cycle phase sectors can be considered.
The 5% Rule of Investment Allocation
One good rule to follow is not to allocate more than 5% to any single sector. Avoid having more than 20% of your portfolio in sectors. You can use between one and four sectors, with 5% given to each. Other stock funds you may be using, such as S&P 500 Index funds, will be exposed to sectors as well. You don’t want too much stock fund overlap, or you’ll defeat the main purpose of using sectors: diversification. Tactical and strategic investing isn’t just to boost returns. It’s also for curbing risk when possible.
