🔄 Sectors and the business cycle

🎯 In 30 seconds: Companies are grouped into 11 sectors under a standard called GICS. Some sectors are cyclical: their profits rise and fall sharply with the economy (cars, airlines, chemicals, banks). Others are defensive: people keep buying their products in a recession (food, medicine, electricity). Knowing a stock's sector tells you what drives it and what it moves with. The popular idea of rotating between sectors as the economy turns sounds neat, but research finds little reliable profit in it after costs.

What a sector is

A sector is a group of companies that make money in similar ways. Companies in the same sector tend to react to the same news: oil prices, interest rates, consumer spending, drug approvals.

The standard most US investors use is the Global Industry Classification Standard (GICS), developed in 1999 by S&P and MSCI. It has four levels: sector, industry group, industry and sub-industry. Every company in the S&P 500 gets one code, based mainly on where its revenue comes from.

Sector labels are not permanent. In a revision that took effect after the close on March 17, 2023, GICS moved transaction and payment processing companies out of Information Technology and into a new sub-industry under Financials. A stock can switch sectors without its business changing at all, which shifts sector funds and sector statistics overnight.

The 11 GICS sectors

The "Usually" column is a tendency, not a rule. A sector's behavior also depends on what is in it at the time. A sector dominated by a few very large companies can behave like those companies rather than like the economy.

Cyclical vs defensive: the math behind it

Why do some profits swing so much more than others? Two reasons.

1. Demand. In a recession people delay buying a car, a sofa or a cruise. They do not stop buying toothpaste, groceries or electricity.

2. Operating leverage. Many cyclical businesses have high fixed costs, costs that do not fall when sales fall: factories, equipment, aircraft, union contracts. When sales drop, profit drops much faster. Here is a hypothetical example, in millions of dollars:

A 20% sales drop wiped out all of A's operating profit. The same thing works in reverse: when the economy recovers, A's profit can multiply while B's barely moves. That is why cyclical stocks can double off a bottom and halve near a top.

The business cycle

The business cycle is the repeating pattern of the economy growing (expansion), topping out (peak), shrinking (contraction or recession) and bottoming (trough). In the US, the official dates come from a committee of the National Bureau of Economic Research (NBER). It defines a recession as a significant decline in economic activity spread across the economy and lasting more than a few months.

Two facts matter for anyone hoping to trade the cycle:

• The dates come late. The NBER says it waits until enough data are in, and tends to identify a peak months after it happened. Its chronology lists the most recent peak as February 2020 and the trough as April 2020.
• Stock prices usually move ahead of the economy. Markets trade on expectations, so stocks often fall before a recession is obvious and start rising while the news is still bad. By the time a recession is official, a lot of the price move may be over.

Sector rotation: the textbook story

Sector rotation is the idea of moving money into the sectors expected to do best in the next phase of the cycle. The classic version looks like this:

The logic for each step is reasonable. Banks and consumer spending often pick up first when rates are low. Commodity producers benefit late in an expansion when demand and prices are high. Defensives hold up when earnings elsewhere are falling.

Where sector rotation breaks down

The problem is the evidence. A 2023 study by Molchanov and Stangl in the International Journal of Finance and Economics tested this conventional wisdom and found little evidence that sectors perform the way the textbook says across the cycle. Any modest outperformance was small and disappeared once they included trading costs and the reality that you cannot call cycle turns perfectly.

The practical reasons:

• You need to know the phase now. Official dates arrive months late, and forecasts of the economy are often wrong.
• The market moves before the economy, so even a correct call on the economy can be too late for prices.
• Each cycle is different. The 2020 recession lasted two months, according to the NBER dates.
• Switching between sectors costs spreads, commissions and, in a taxable account, taxes.

How to use sectors in practice

• Know your exposure. List the sector of every stock you hold. Five stocks in one sector is one big bet. Diversification and correlation shows why stocks in the same sector tend to fall together.
• Compare within the sector. Margins, ratios and growth rates should be compared with companies in the same industry. See Valuation ratios.
• Read the drivers. For an energy stock, watch oil prices. For a bank, watch interest rates and loan losses. For a homebuilder, watch mortgage rates. The economy and stocks covers the main reports.
• Treat cyclicals' low P/E with care. A cyclical company's P/E often looks lowest at peak earnings, right before profits fall.
• Use relative strength as a fact, not a forecast. Seeing which sectors are leading is useful context for a trader. It does not tell you how long it will last. Momentum trading covers how traders use it.

Try it

Open the Market dashboard or Index dashboard and note how the broad market did over the past month. Then use the Stock screener to find two companies in Consumer Staples and two in Consumer Discretionary. Add them to your Watchlist. Over the next few big down days in the market, record how each moved. Do the defensives fall less? Write down what you see, not what you expected.

Then rework the A and B table: what happens to each company's operating income if sales rise 20% instead? (Answer: A goes from 100 to 200, up 100%. B goes from 150 to 230, up 53%. The same operating leverage that hurt A in the recession helps it in the recovery.)

Sources

• MSCI: The Global Industry Classification Standard (GICS)
• MSCI: GICS sector definitions, effective March 17, 2023 (PDF)
• S&P Dow Jones Indices and MSCI: Revisions to the GICS structure in 2023
• NBER: Business Cycle Dating
• Molchanov and Stangl (2023): The myth of business cycle sector rotation (Massey University repository)