How to Tie Together the Business Cycle and Asset Allocation

In a previous article, we explored a basic way of finding the optimal portfolio composition, given certain constraints and certain assets. In this article, we shall explore a simple way to understand which group of assets might be better suited to enter into the optimization process. We will do this asset selection process based on our beliefs of the current state of the business cycle.

Investing and the Business Cycle

Stated simply, the business cycle (which is also often referred to as the economic cycle or stock market cycle) simply refers to alternating periods of simultaneous expansion in economic activities, followed by a similar contraction in the same activities. This sequence is repetitive, but is not periodic, meaning that a business cycle can last from a few years to more than a decade. The business cycle approach offers potential to take advantage of relative sector performance opportunities. As the probability of a phase shift increases, the strategy allows to adjust exposure to capture the best performing sector. Also, the cycle phases will, on average, rotate every few months to few years so it makes it somewhat easier to execute than tactical short term approaches.

The business cycle approach offers potential to take advantage of relative sector performance opportunities. As the probability of a phase shift increases, the strategy allows to adjust exposure to capture the best performing sector. Also, the cycle phases will, on average, rotate every few months to few years so it makes it somewhat easier to execute than tactical short term approaches. In this article we have explored two possible methods that can allow you to assess with a certain degree of robustness where we are in the business cycle, and take appropriate actions. As with all things market related, history is no guarantee of future outcomes, but armed with this knowledge you should be able to make better decisions.

References:

http://www.clevelandfed.org/

https://research.stlouisfed.org/fred2/

https://dsgoldsmith.com/

https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/si_business_cycle.jhtml?tab=sibusiness

http://economistsview.typepad.com/economistsview/2005/08/the_use_of_lead.html

Forecasting Output and Inflation: The Role of Asset Prices (Stock & Watson)

http://www.econedlink.org/economic-resources/focus-on-economic-data.php

http://stockcharts.com/h-sc/ui