Sector Business Cycle Analysis

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There are different investment approaches to identify sector winners and losers, such as price momentum strategies, top down approach based on specific macroeconomic indicators or bottom-up approaches to identify sectors with improving fundamentals. One widely used approach is business cycle analysis. Since economic cycles usually exhibit characteristics that impact sectors or industries differently, investors may identify sectors that are favored by the current economic phase.

A standalone business cycle based sector rotation is difficult to implement, as differences exist on economic conditions of each cycle over time and transformative technology continues to alter business models and economic impact. However, understanding cycle dependency on sectors is important to sector portfolio construction, particularly for a top-down approach.

To make a quantitative and systematic assessment of how different sectors performed through various business cycles, we used the Conference Board Leading Economic Indicator Index (LEI) to segregate business cycles and evaluated sector performance over multiple business cycles between 1960 and 2018. This provided a good sample size to evaluate sector performance persistency for different cycles.

Understanding and Defining Business Cycle

The concept of a business cycle was first introduced by Wesley C. Mitchell and Arthur F. Burns. They took the indicator approach that uses cyclical economic indicators to explore patterns of economic fluctuations.

“Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge into the expansion phase of the next cycle.” — Wesley C. Mitchell and Arthur F. Burns1

First published by the U.S. Department of Commerce as part of the Business Cycle Indicators program in late 1960s, the Conference Board’s LEI Index follows this approach by aggregating ten economic indicators (See Appendix II), ranging from employment, business orders and financial conditions to consumer expectations, to summarize common turning point patterns in economic data. The indicators included in the composite index have survived a wide variety of statistical and economic tests, such as consistency, economic significance, statistical adequacy, smoothness and promptness.

Most of the research on business cycles defines only recession and expansion through identifying peak and trough. However, we believe there are more nuances in different stages between a peak and trough. Therefore, we divided the business cycle based on the direction and magnitude of changes of the Conference Board LEI Index.

The chart below shows the delineation between these parts of the cycle.

  • Recession: The LEI Index declines to a trough at an accelerating pace2
  • Recovery: The LEI Index rebounds from a trough but below long-term trends
  • Expansion: The LEI Index YoY changes are positive and above long-term trends

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