Defensive vs. Growth Market Cycles

Do you know what a “defensive” market cycle is? How about a “growth” cycle?

Here’s a hint: We were in a defensive cycle for the majority of the first part of 2013, although towards the beginning of summer, we began transitioning into a growth cycle.

What does that mean? Read below to find out.

Defensive and Growth Cycles

Glance at a chart showing any asset that trades in the capital markets. You’ll spot a pattern of successive peaks to troughs and back to peaks again. If you remember high school trigonometry, you will recognize the familiar shape of a sine curve. This sine curve represents the cycle.

In the equity markets, one of the most common cycles is the regular trade-off between defensive industry sectors like utilities and consumer staples, and the more growth-oriented sectors like technology and materials. Defensive and growth sectors tend to do well at different times, for reasons relating to the overall ebb and flow of the economy.

When the storm clouds are brewing and a recession looks imminent, the defensives tend to take over. The reasoning behind this is simple: household budgets may be constrained in a downturn but people will still need to buy toothpaste and pay their electric bills.

On the other hand, when we are in the early period of acceleration out of the bad times, businesses will start investing in the assets they anticipate will be needed to meet increased demand for their products and services. Growth sectors will tend to outpace the broader market.

Catalysts and Transitions

Of course it’s hard to pin down cycles in the real world. In the first four months of 2013, the general consensus about the U.S. economy was that growth was improving, if slowly. Unemployment was trending downwards, retail sales were up and the housing market was showing signs of finally coming to life after five years. Yet the stocks leading the rally for much of this time were defensive: utilities, consumer staples and healthcare were the strongest performers among the ten major S&P 500 industry sectors.

More recently, though, traditional growth sectors like technology have been leading market rallies even though many observers think equity markets generally are overextended and due for a pullback. The reality is that cycles tend to be sparked by catalysts that sometimes seem irrational, and the transition between the cycles can be anything but smooth.

Time Periods Matter

In general, the longer view you take, the smoother the cycle will appear to be. In analyzing things like asset performance, the short-term environment tends to be “noisy” with lots of conflicting data points. For example, if you are looking at the returns of some asset over the past 30 days you will probably see choppier cycles of short and inconsistent length. If you look at the same asset’s performance over 3 years or 5 years, the contours of the cycle will most likely seem clear.

Going even further, “macro” cycles can play out over not just years but decades. The last macro bull cycle in equities went 18 years from 1982 to 2000, and we’re still in the macro cycle in interest rates that began in 1981.

Those long cycles can have an impact on your retirement, college savings plans and other long-term objectives, so it’s a good idea to have some understanding of how they work. But beware the perils of trying to actively play those noisy shorter-term cycles.

Are we in a growth cycle or a defensive cycle? Tell us what you think.