Topic: Daily Advice

Rise above stock market cycles with a sound portfolio approach

January 14, 2016|by Jim Bates

Stock market cycles occur repeatedly—but instead of trying to time them, focus on building a portfolio of high-quality stocks

Stock market cycles occur repeatedly—and there are any number of theories as to which sectors will outperform at any given short term stage of the cycle. But trying to pick winning sectors—and staying out of other sectors—seldom works over long periods. That’s because to succeed, you need to guess right twice. You have to pick the top sectors, and then pick the stocks to rise within those sectors. Consistently succeeding at both is extremely difficult.

A good example is the resource sector. Many investors wonder whether if at this point in the current stock market cycle the resource sector is simply plagued by too many drawbacks to deserve a permanent spot in your portfolio.

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Investor awareness goes through cyclical swings

When times are good in the stock market cycle, investors ignore investment drawbacks and pitfalls. When times are bad, as they are right now for oils and other resource stocks, investors pay too much attention to risk.

Resource companies do produce and sell commodities. So it’s hard for them to bring a distinct product to market. But they can distinguish themselves by how well they find and produce their products. Today’s resource projects call for a great deal of engineering, financial and political expertise. The top resource companies—like Imperial Oil or Encana—acquire a lasting competitive advantage—though all stock market cycles—by developing their expertise in these areas.

This expertise is another type of hidden asset. It doesn’t appear on the balance sheet, but it gives the top resource stocks an advantage in every project they undertake.

Resource companies do sometimes turn out to have hidden environmental liabilities, as do companies in other sectors. But the top resource stocks also create their own hidden assets. They accumulate rights to promising acreage long before the land rush starts. They have the technical and political skills they need to foresee and deal with environmental and political obstacles.

This expertise becomes more important as resource technology advances. For instance, recent advances in oil and gas drilling technology helped bring on the plunge in oil prices at this point in the stock market cycle. The new technology made it possible to vastly increase oil production, even from deposits that were once considered worthless.

Resource stocks, though volatile, tend to rise with inflation
The resource sector is subject to wide and unpredictable swings in the prices it gets for its products. In the rising phase of stock market cycles, when business is booming, resource demand expands faster than resource supply, so resource prices shoot up. This balloons profits at resource companies. When the economy slumps, resource prices fall, and this drags down resource profits and stock prices.
In addition to rising and falling with the stock market cycle, however, resource stocks have a history of rising along with long-term inflationary trends. This gives them a rare ability: they provide a hedge against inflation.

The four-year rule is one stock market cycle well worth following

We’ve often written about the four-year cycle. We’d say it’s the single best investor aid we’ve come across, and it’s really quite simple.

The U.S. stock market—and in turn the Canadian market—seem to take something of a cue from the predictable events and phases of the four-year U.S. Presidential cycle.

The newly elected or re-elected President usually uses the first two years of his term to clean up any lingering problems or nasty necessities. That way, he faces a less problematic situation in the second half of the term. That improves the chances of an election victory for the President himself, or his chosen successor.

This pattern creates uncertainty or worse in the first two years of the term. That holds the market down or leads to a setback. It often seems to lead to a particularly attractive buying opportunity sometime around the mid-term Congressional elections, which are held in the middle of each four-year presidential election.

After that buying opportunity, stock prices often head upward, with the usual surges and setbacks of any phase of stock market cycles, for a couple of years.

Obviously, this stock market and presidential elections relationship is just a general tendency. We continually take it into account, since it is the most reliable market tendency we know of. But it is just one of a number of factors we look at in our recommendations.

Profiting in every stock market cycle

Market downturns are inevitable and markets will always swing back up again. All in all, the best way to insulate yourself from market cycles is to invest in quality blue chip companies.

Even during tough economic times, blue chip companies still pay dividends. These tough stock market cycles are also excellent times to purchase solid blue chip companies.

3 ways to invest for every stock market cycle

1. Invest mainly in high quality stocks.
It’s essential to invest in stocks that have some history of sales, if not profits or cash flow. If you break this rule and invest in, say, junior mines or tech startups, you should only do so if you have a high opinion of the value of the junior’s assets and/or business plan, and you buy with money you can afford to lose. After all, you could very well be mistaken about their value. Your low-quality buys might eventually wind up worthless.

2. Spread your stocks over the five main sectors.
If you diversify across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities), and stick mainly to high quality blue chip stocks—then you can be almost certain of long-term gains in excess of what you’d get with any other investment approach.

3. Avoid or downplay stocks in the broker/media limelight.
Investors can build up unrealistic expectations when blue chip stocks spend time in that limelight. When broker/media favourites fail to live up to those expectations, they drop much further than they would have if they had been less widely followed.

Also, “holding for the long term” usually only pays off with investments in high-quality stocks. If you buy low-quality or speculative stocks, time tends to work against you. The longer you hold them, the likelier you are to lose money.

How have you insulated yourself from bear stock market cycles? Were you overly optimistic the last time the stock market cycle changes? Share your experience with us in the comments. 

Note: This article was originally published in 2007 and has been updated.