Markets
Understanding the business cycle and sector rotation
By Michael Morris 19 June 2025 7 min read
We are all aware of how the economy can feel to us personally. At times it is humming along, businesses are opening, restaurants are full and the general mood is positive. At other times, it can seem to be stuck in the mud, with the pace of business activity significantly slowed down. This oscillation between the extremes of boom and bust is known as the business cycle.
In this article, we’ll break down the four distinct phases of the business cycle. We’ll examine the underlying conditions that define each phase, which will help us understand why certain sectors of the stock market tend to perform better at different times. We’ll also explore how understanding these cycles can help you build a more resilient portfolio by introducing an investment strategy known as sector rotation.
What is the business cycle?
The economy moves in discernable patterns, often described as the business cycle. This cycle isn’t a steady, predictable march; it ebbs and flows through distinct phases: early-cycle, mid-cycle, late-cycle and recession. As the economy moves through these phases, it influences factors like corporate earnings, interest rates and inflation among a myriad of others.
While each cycle has its own unique characteristics, understanding the underlying rhythms can be beneficial for investors. Becoming familiar with the business cycle can help investors evaluate and adjust their exposures to different types of investments.
Lets look at the conditions that define each phase of the cycle:
Early-cycle
Following an economic downturn, the economy begins to stabilize, and a robust rebound often occurs. Key indicators like Gross Domestic Production (GDP) and industrial output shift from negative to positive, signaling accelerating growth. Credit conditions become more favourable and low interest rates support increased profitability. Businesses begin to work down inventory as sales pick up. This sets the stage for renewed growth as the economy begins to find its stride.
Mid-cycle
Typically the longest phase, characterized by steady economic growth. Momentum in the economy continues to build, credit remains accessible, and businesses enjoy healthy profitability. During this phase, unemployment tends to fall and wages may see increases, leading to strengthening consumer confidence and spending.
Late-cycle
Economic activity reaches its maximum output. Growth remains positive but is decelerating. Signs of an overheating economy may emerge, including rising inflation and tight labor markets. Central banks may respond by raising interest rates in an attempt to cool off the economy and control inflation. This phase marks the turning point where the expansion begins to run out of steam.
Recession
Economic activity declines, corporate profits contract, and credit is less accessible for businesses and consumers. Unemployment begins to rise as companies reduce production and attempt to cut costs in response to decreased demand. Interest rates are cut by central banks in an effort to stimulate the economy. The cycle of bad economic news creates a vicious circle where consumers and businesses will delay consumption in an attempt to wait out the bad economy, which can lead to more poor economic news.
Sector performance by phase
This section looks at the various phases of the business cycles and which sectors have historically outperformed during each phase due to the underlying economic conditions.
Early-cycle
Coming out of recession, this phase can be short lived but is marked by a renewed optimism and a change in sentiment. Households that may have put off spending decisions during the recession, now feel more comfortable to go out and make purchases, especially bigger ticket items. This benefits stocks in the consumer discretionary sector. As consumers increase their spending, and perhaps even take on new borrowing, businesses are moving quickly to replenish inventory to meet rising demand which benefits industrials. This increased borrowing provides a boost to bank and credit card company stocks, and the overall financial sector. It's also during this period that the real estate market often experiences a rebound, as renewed confidence encourages home buying and investment.
Mid-cycle
Sentiment is positive during this phase as the economy is experiencing widespread growth. The adage “a rising tide lifts all ships” applies to the stock market as all sectors are expected to do well. In this phase of the business cycle, some stock market sectors shine more brightly than others. Interest rate sensitive stocks, like those in the consumer discretionary, energy, and financial sectors often perform well as interest rates remain at levels that promote economic activity. Stocks in the industrial sector perform well as economic output is strong and companies are replenishing their inventories. The technology sector also tends to exhibit strong performance, benefitting from increased business investment and consumer spending. The mid-cycle expansion phase is the longest of the business cycle and in market parlance the stock market is said to be in a bull market.
Late-cycle
Interest rates tend to rise as inflation has picked up due to increased demand and an attempt to decrease credit demand to combat inflation.
In this environment, sectors that are less sensitive to economic slowdowns tend to perform relatively better. Energy and utility companies often do well as demand for their products is steady. As consumers cut back on non-essential spending, consumer staples stocks tend to hold up better than those in the consumer discretionary sector, as their earnings projections should be more consistent. Investors following a sector rotation strategy need to be nimble at the stage of the cycle as the shifting economic winds suggest caution.
Recession
Characterized by a slowdown in economic activity, where GDP is contracting. Businesses will respond to reduced demand by cutting back on both inventory and employees, leading to rising unemployment. The economic outlook causes consumers to postpone big ticket purchases, further exacerbating the downward economic pressures, creating a negative feedback loop.
As earnings expectations drop, stock prices follow suit. Most stocks will suffer in the downturn however those stocks considered defensive, including healthcare, utilities, and consumer staples, can be a place to hide out. The technology sector can offer resilience as investors begin to look ahead and companies in this sector have the potential to grow quickly as economic prospects improve.
Source: ATB Wealth
Sector rotation
Now that we have a better understanding of the phases of the business cycle and which sectors could be expected to outperform, let’s build on that knowledge by looking at an investment strategy known as sector rotation.
Sector rotation is an active investment strategy that involves shifting investment capital between sectors of the stock market based on where the investor judges the business cycle to be. The investor will attempt to increase their exposures to the sectors expected to outperform and decrease the exposure to those expected to underperform according to their analysis.
The goal is to enhance portfolio returns by being strategically positioned in the sectors with the highest potential for growth or resilience during a particular economic climate. This requires a proactive approach, constantly monitoring economic data and adjusting sector allocations as the business cycle evolves.
How sector rotation works in practice
- Attempt to identify current business cycle phase: This involves analyzing various economic indicators to determine whether the economy is in the early, mid, late or recession phase—and whether it may be poised for a transition.
- Allocate to historically leading sectors: Based on the identified phase, investors then allocate a larger portion of their portfolio to the sectors that have historically demonstrated strong performance during that particular stage. For example, if economic indicators point towards an impending recession, an investor might decrease their holdings in cyclical sectors (such as consumer discretionary and financials) and increase their exposure to defensive sectors (such as consumer defensives, utilities, and healthcare).
- Monitor and adjust: Sector rotation is not a static strategy. It requires ongoing monitoring of economic data and a willingness to adjust sector allocations as the business cycle evolves and transitions into the next phase.
If an investor were to implement a sector rotation strategy they would want to first understand their current portfolio exposures. Next investors may increase their exposures to overweight those sectors expected to outperform and underweight those sectors expected to lag. This can be accomplished through adjusting your exposures using sector-focused exchange-traded funds (ETFs) or holding actively managed mutual funds or ETFs. In the case of the latter, the portfolio manager is making tactical tilts on your behalf, leveraging their expertise in an attempt to deliver enhanced returns for investors.
Considerations and risks
While the concept of sector rotation seems straightforward, it's crucial to understand its limitations and risks.
- Difficulty in predicting cycle transitions: Accurately forecasting the transitions between business cycle phases is challenging, and mistiming these shifts can lead to underperformance.
- Historical patterns may not repeat: The historical relationships between sectors and the business cycle may not always hold true due to unforeseen events or structural changes in the economy.
- Transaction costs: Higher transaction costs, such as trade commissions and taxes, can be associated with frequent trading and could erode potential gains.
- Concentration risk: Focusing heavily on specific sectors can lead to a lack of diversification, increasing the portfolio's vulnerability if the anticipated sector performance does not materialize.
Final thoughts
Understanding the ebb and flow of the business cycle is crucial for investors seeking to build a resilient portfolio. By recognizing the four distinct phases of the business cycle and the sectors that historically outperform, investors can then employ a strategy like sector rotation. While challenging to execute perfectly, aligning investment decisions with the prevailing economic winds offers a proactive approach to potentially enhance returns and navigate the inherent volatility of the stock market.
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