Many retail investors and traders don’t realize that the overall stock market is driven by something much larger than corporate earnings or weekly FED data.
The biggest influence on the various sectors of the stock market is non-other than the actual U.S. business cycle.
If you can correctly identify the current phase of the business cycle…you can target sectors that respond best in that particular cycle.
The typical business cycle is divided into 5 different stages and can take several years to complete, before starting all over once again.
The first stage of the business cycle is early expansion stage. This stage of the business cycle causes large institutional money to flow into the stock market.
Interest rates are low during the early stage of the business cycle and economy is expanding aggressively.
This is the stage of the business cycle when both speculative and blue chip stocks rise aggressively.
During the early expansion cycle Investors tend to ignore basic fundamentals like P/E ratio and focus on future projections and anticipations.
The second stage of the business cycle is the mid-expansion phase. During this stage of the business cycle, economy continues to expand but not nearly as fast.
Hedge funds tend to become increasingly cautious about the economy and become much more selective about their selection process.
Tech continues to lead but basic materials begin to expand as well due to increased infrastructure development that was caused by the first stage of the cycle.
The next stage of the cycle is the late expansion phase. This is when interest rates begin to rise and institutional investors begin to diversify into commodities and assets that are diversified from the overall stock market.
Gains in tech slow down and stocks that are sensitive to higher inflation start outperforming tech ad blue chip.
During this stage of the business cycle, stocks become prone to increased false breakouts and trend following systems start moving into periods of prolonged draw-downs and volatility levels increase substantially.
The next stage of the business cycle and one that investors hope never comes is the early contraction stage.
Bears to begin gaining control of market action and stocks start trading below the 200 day moving average.
Institutional investors and retail traders begin targeting defensive stocks and short term rates spike with increased frequency.
During this stage of the business cycle commodity priced decline and GDP slows down sharply, it becomes clear that economy is headed into deep economic recession.
The final stage of the business cycle and the most devastating one is the final contraction stage. In this part of the cycle we see sharp a sharp economic recession.
Bond prices rise substantially and stocks prices go through their final stage of correction.
The only sectors of the economy that respond to accumulation are financials and consumer cyclical industries, while most others continue to trade below the 200 day moving average.
All in all, the current business cycle dictates to a large degree which sector of the economy will rise and which segment of the economy will stagnate.
These 10 major sectors represent the U.S. economy. Every sector favors different part of the economic cycle.
Some sectors respond best in the early expansion cycle while others respond best in late contraction.
If you can match the right cycle with the current economic cycle, you can drastically increase your percentage of winning trades.
If you don’t the current economic business cycle into account when which sector to allocate, you’re going to end up fighting the long term trend.
This will decrease your percentage of winning trades, cause you to stay in losing positions longer and worse of all decrease the size of winning trades.
And worse of all, it will sharply jeopardize or distort your trading methodology and turn a highly successful winning strategy into a loser.
In conclusion, always take into account the current stage of the business cycle and know which of the 10 major sectors responds best.
Knowing which sector soars and which sector falls during every stage of the business cycle will help you gain an unfair advantage and give you a strong edge, regardless of the trading strategy or the time frame you utilize in your trading.