How Stock Market Sectors Depend on the Business Cycle

For investors with longer time horizons, the primary drivers of portfolio returns are the business cycle and other longer-term trends. The business cycle refers to the cyclical upswings and downswings in economic activity that often drive the performance of areas of the stock market. That is, the business cycle impacts not only the broader stock market and interest rates, but individual sectors (or areas of the market) as well. What can long-term investors do to maintain perspective throughout the business cycle?

Sectors can be cyclical or defensive relative to the business cycle

Cyclical sectors are ones that typically perform well when the economy is recovering from a recession or is in a period of growth. For example, Consumer Discretionary businesses (like restaurants, hotel chains, or home appliance manufacturers) generally benefit from growing consumer spending and confidence which depend on the health of the economy. In contrast, defensive sectors like Utilities are those that typically perform well relative to the broader index when the economy is slowing.

The chart above shows the performance of market sectors ranked from best to worst each year since 2008. One of the key takeaways from the above is how difficult it is to predict relative sector performance in any given year. This year, technology-related sectors have outperformed due to trends like the enthusiasm for artificial intelligence, but this is a sharp reversal of last year's dynamic. Given this history, it makes sense for disciplined investors to stay diversified across sectors - possibly with the occasional portfolio tilt to take advantage of trends across all areas.

The business cycle is what matters for long-term financial success. This directly impacts sector performance which can be difficult to predict. Disciplined investors should continue to stay diversified across sectors as the cycle unfolds.

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