Where Are We in the Current Business Cycle?
How to Protect Your Investments in Any Phase
Many people don't recognize the business cycle well. So before Great Recession hit, they did not get out of the stock market in time. On the other hand, many people often fear putting too much money into the stock market in the beginning of the expansion cycle, when it is the right time to do so.
Although you can't time the market, you can improve your returns by knowing where we are in the business cycle. You can then adjust your asset allocation to take advantage of the phases.
The line chart below shows how a business cycle can be used to plot the rise and fall of the GDP to track the expansion and contraction of the U.S. economy after World War II.
- Expansion: The economy grows a healthy 2 to 3 percent. Stocks enter a bull market.
- Peak: The economy grows more than 3 percent. Inflation sends prices up. There are asset bubbles. The stock market is in a state of "irrational exuberance." Talking heads announce we are in a "new normal." Authors publish books entitled "Dow 30,000."
- Contraction: Economic growth slows but isn't negative. Stocks enter a bear market.
- Trough: The economy contracts. That signals a recession. Economic experts predict it will continue for years.
Since June 2009, the economy has been in the expansion phase. That's nine years. Historically, expansion phases last five years or so. As a result, many people are warning that a recession is just around the corner.
But there hasn't been any inflation. That’s a typical warning sign that expansion is reaching its peak. Instead of inflation, there are asset bubbles. In 2015, it was in the U.S. dollar. The weak demand for the euro contributed to a strong dollar. There was an asset bubble in housing prices right before the 2008 recession. Sometimes the irrational exuberance of a peak takes place in asset prices without generating overall inflation.
How to Protect Yourself in Each Business Cycle Phase
You should consult a certified financial planner to find specific funds or stocks. But there are generally-accepted guidelines for what tends to do better in each phase of the business cycle:
Contraction: Sit tight. If you haven’t sold stocks by the time the economy contracts, it’s probably too late. You could move some assets into bonds or cash, but keep some in stocks. You want to catch the rebound when it occurs. Most investors sell stocks when the contraction is already well underway and don’t buy them until it’s too late. A recession or bear market usually lasts six to 18 months.
Trough: Start adding stocks and commodities such as gold, oil, and real estate. They should be cheap during a recession.
Expansion: In the early stages of an expansion, small-cap stocks grow the fastest. That’s because small companies are nimble enough to take advantage of a market turnaround. You can gain extra income with high-yield bonds. Add stocks and bonds from foreign developed and emerging markets. They hedge against a declining dollar. Emerging markets grow faster in the early stages of an upturn. For example, Brazil’s banks didn’t purchase subprime mortgages. Its economy grew when the U.S. economy was in recession.
Emerging markets are risky, but as the global economy improves, that risk is worth it. Later on in the expansion, add mid-cap and large-cap stocks. Larger companies do better in the late stages of a recovery.
Peak: Sell stocks, commodities, and junk bonds. Increase the proportion of cash and fixed income. The safest are U.S. Treasury bonds, savings bonds, and municipal bonds. When interest rates are high, buy and money market funds. As interest rates fall, a switch to corporate bonds provides a higher return with greater risk. Add gold until it's about 10 percent of your portfolio. It's a good hedge against inflation. It’s also the best protection during a stock market crash. That's because gold prices rise for 15 days after any crash.
This is why you should invest in gold.
As you can imagine, it's incredibly difficult to sell stocks when everyone else is bragging about how much they're making. That's why timing the market is almost impossible. Instead, be conservative. Never have 100 percent of your investments in any one asset class.
Instead, make sure your investments are diversified. Gradually shift the proportion to stay in tune with the business cycle. Always work with a financial planner to make sure the allocation matches your personal goals.