Fundamental Analysis Of Stocks - Business Cycles

Markets don’t move in a linear path, there are Ups and Downs. When the up moves are stronger and larger, we say the market is in an expansion phase. When the down moves are stronger and larger, we say it is in a contraction phase. Both these phases happen alternatively, leading to what we call cyclicals. Needless to say, returns are good during the expansion phase, while returns could be flat or negative during the contraction phase. Our goal is to ride the expansion phase to the maximum possible extent, while protecting capital and shift our investment to more durable areas during the contraction phase. This forms the basis for generating superior returns on our investments. Hence, it becomes necessary to understand business cycles, market cycles and macro-economics to help us take better decisions on our equity investments.

Market cycles and Business cycles, though used interchangeably, are not actually the same. Market cycle is more focused towards the cyclical nature of the stock market, where the stock market moves due to the inherent psychology of market participants, be it retailers, FII, DII, Promoters etc. It is more technical than fundamental analysis. It is better described by the Boom-Bust cycle where the human emotions gets projected on the stock market in terms of 4 phases, Accumulation, Uptrend, Distribution, Downtrend. This is explained well by the Dow Theory.

On the other hand, Business cycles are more related to the broader economic activity (Macro-Economics) which in turn is responsible for influencing the market cycle itself. Like market cycles, the economy also moves in and out of expansion and contraction phases which may last a few months to several years. Though this is cyclical in nature, there is no uniformity of the occurrences. A prosperous economy can be interrupted for various reasons, where the underlying business conditions deteriorate. Likewise, a prolonged economic crisis leads to newer opportunities and possibilities for the economy to recover and once again go through expansion. Before WWII, most of the crisis were triggered by war, political instability and revolution. But in recent times, crisis were caused due to varied reasons such as technology advancements, debt and health crisis. This led to various theories on how business cycles are triggered.

1. External/Internal Cycle - War, Political Instability and Revolution

2. Supply/Demand Cycle - Production vs Consumption

3. Credit/Debt Cycle - Monetary Policy Induced Interest Rates and Borrowing.

4. Political Cycle - Conservative vs Expansionary Ideology

Purists would propose and dispose of one theory over another, but as investors, we need to take a middle ground to understand that all theories are interlinked. Whatever induces a shift in the business cycle from expansion to contraction or vice-versa, there would be multiple factors playing itself in terms of fiscal policy, monetary policy, trade policy and supply/demand of the consumables. For example, the debt crisis of 2008 ultimately impacted supply, due to which the Central banks across the world took monetary policy measures. Eventually, the contraction led to electoral changes. Thus a trigger could happen due to any cause, but the domino effect plays across all areas of the economy, thereby fulfilling all the theories.

So, how does understanding the business cycle help the investors in making good investment decisions? Though the business cycle gets triggered at a macro-level, the impact percolates to the various business sectors in the country and ultimately the stock market as well. While the cycle goes through the expansion/contraction phase, not all business sectors are affected to the same degree. The cycle plays a big role in giving a supportive hand to certain sectors, while punishing other sectors during a contraction phase. This depends on the theme of the phase. For example, in the COVID19 pandemic induced contraction phase, the Pharma, IT and Telecom sectors had favourable conditions. But labour intensive sectors such as Industrials and Capital Goods, Consumer Discretionary etc, faced significant difficulty and under performance. Generally, during an expansionary phase, Industrials, Consumer Discretionary, CapEx supportive industries(Capital Goods, Imports, Industrial Equipments etc) tend to do well, because the business confidence, employment rates, income/expenditure and thereby demand are high. But during a contraction phase, defensive sectors such as Public Sectors, Health & Pharma, Consumer Durables etc, do well due to the fear of uncertainty, unemployment and debt. Also, the theme of the contraction could also lead to sectoral biases. Since each expansion and contraction is unique in terms of ever changing global economy and consumer preferences, the relevance of the sectors and the individual companies also changes. Even within a supposedly beneficiary sector, some companies are more suitable to grab the opportunity to make full use of the tail winds effectively.

In hindsight, it would have been beneficial to cut positions on negatively impacted sectors and add on positively impacted sectors. But the hindsight should be converted to foresight, to keep us ahead of the curve. So, identifying the direction and current structure of the business cycle and the theme of the phase can greatly improve the returns on our investments. A business cycle can last anywhere between a year and 5-6 years. Having exposure to under-performing sectors for a large part of the business cycle could severely impact the returns that you can generate on the capital deployed. Hence it becomes essential to identify changes to business cycles as early in the cycle as possible and assertively take action on it. It is not about timing the market, which everyone despises, rather, it is about adapting to change. This would be the first step in fundamental analysis for building an effective equity portfolio, where you are required to assess the current economic conditions and the current phase of the business cycle. Once analysed, you would be able to identify the ideal sectors to be invested in and the sectors to avoid. This greatly reduces the number of stocks which are on your watch list to monitor, thereby focusing more on more realistic opportunities. Having a cluttered watch-list will lead to confusion. As and when the underlying economic conditions change, the sectoral biases should also be changed to restructure your portfolio, to keep it relevant to the ongoing theme of the economy. Adaption to reality, in terms of economic data, is your first tool to avoid bad decisions on investments. In the next article, we will look at the various macro economic indicators that can help you on the decision making.