Is Your Portfolio in Sync With the Economy?

published 31 December 2006

The U.S. economy has been growing nonstop for more than five years -- nowhere near the record of ten years beginning in 1991, but a good, long run. Although we don't expect a recession anytime soon, no economic expansion lasts forever. Since World War II, the average expansion has lasted nearly five years. As this one ages and eventually ends, it will have a marked impact on the behavior of stocks.

True, a company's ability to increase sales and profits is the biggest factor in its stock performance. But the economy's ups and downs often heavily influence the pace of that growth. Some stocks -- those of homebuilders, for example -- do best when the economy is booming and people feel prosperous. Other stocks, such as those of pharmaceutical manufacturers and producers of food and beverages, hold up better in a downturn. Stocks of young, fast-growing companies (think biotech and fledgling Internet firms) tend to move independently of the economy's cycles.

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The popularity of sector-oriented exchange-traded funds makes it tempting to try to time these cycles to increase your overall returns. But to do so profitably, your forecasts would have to be uncannily accurate and consistent. Stock prices usually react to economic changes six to nine months before the changes occur. What's more, stocks and sectors don't always behave according to the script. Shares of utilities, for instance, have been among the stock market's best performers this year, although they typically shine in a weak economy.

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As businesses struggle to cope with an economic downturn, inflation fears recede and interest rates fall. This is good news for utility stocks. Utilities are defensive businesses to begin with -- homes and office buildings always need to be heated and cooled. But utilities also borrow millions of dollars to build power plants, so lower interest rates mean higher profits. Falling rates are also good for consumer-related financial firms, such as mortgage lenders, regional banks and credit-card companies. Their stocks tend to perk up as the downturn nears an end and investors begin anticipating better times.

Optimism abounds as the economy emerges from a recession and is once again growing. Businesses are hiring, and consumers are confident enough about their prospects that they're willing to loosen their purse strings. At this point, stocks of companies that make so-called durables -- longer-lasting consumer products that are sensitive to the business cycle -- begin a steep upward trajectory. It's a good time to own makers of big-ticket items, such as refrigerators and high-end gadgets, as well as retailers.

As the economy continues to expand, this is a good environment for commercial lenders and investment banks. It's also a good time to own makers of industrial machinery and heavy equipment. Such businesses have high fixed costs, but when revenues rise enough to cover those costs, profits soar. With factories running at full capacity, transportation stocks perform well because more raw materials and finished products are being shipped. Demand for energy also surges, thanks to the increased business activity and consumer spending on things such as bigger homes and vacations. Demand for goods and services, in general, begins to outstrip supply, which causes prices to rise and boosts inflation-sensitive precious-metals stocks.

This is where we stand today. The economy expanded at an annual rate of just 2.0% after inflation in the third quarter, far below the torrid 5.6% growth rate in the first quarter. And once the economy begins to slow, businesses and consumers become more careful about how they spend their money. Although a recession isn't in the cards, this is a good time to own stocks in defensive industries -- companies that make products that are always in demand, regardless of the economic circumstances. They include makers of food, beverages, tobacco and household essentials, such as toothpaste and toilet paper. Demand for health care remains fairly constant throughout the cycle, too, so it's also a good time to invest in drug makers, producers of medical devices and hospital chains.

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