Are You Prepared for The Next Stage of the Market Cycle?

There’s one big question on many investors’ minds: When will everyone stop talking about a recession and focus on growth again? It could be a while – after a decade that saw overall stock market growth¹ and decent economic activity, Canada is looking to climb out of a late-stage economic cycle that has been marked by slower growth, ongoing inflationary pressures and elevated interest rates.

It took longer than usual to get to this phase, but, eventually, the cycle will turn, says Jonathan Aikman, an Adjunct Lecturer at Queen’s University’s Smith School of Business who teaches graduate and executive courses on finance. “We’ve had a huge bull market driven by extremely low interest rates, which has delayed the normal business cycle,” he says.

You likely don’t want to try and time the market, but you can still pay attention to when the business cycle might shift so you can feel prepared to adjust your investment strategy accordingly. Investments that do well in a late stage often differ from those that outperform in the early stage, when economic activity starts to increase and consumers feel good about spending again.

Understanding the investment cycle
There are usually three stages to every economic cycle (also called business or investment cycles), each of which affects investment markets differently. Below is a rundown on the general characteristics of each phase.

Early stage
Typically, interest rates come down in this phase, consumers and businesses start to borrow, employment rises, and gross domestic product (GDP) begins to expand. Generally speaking, small-cap companies and cyclical sectors, such as financials, industrials, materials and energy, benefit as growth picks up.

Peak stage
Here, the economy is humming along, with labour markets strong and demand for consumer goods hitting a high point. Prices and wages often start climbing, causing central banks to raise rates to combat inflation. In this phase, consumer discretionary stocks – companies that produce things people want, but don’t necessarily need – tend to do well, as do high-growth sectors like tech.

Late stage
In the last stage, economic growth slows, and consumer spending tends to drop, causing earnings forecasts – and stock prices – to decline. Layoffs may occur, and the word recession starts to creep into the conversation. Central banks often start lowering interest rates to increase growth. This is the type of environment that tends to benefit slow and steady sectors, such as consumer staples, healthcare and utilities.

“This late-stage cycle could be worse than in the past, as we’ve delayed getting here, but the early stage will come,” says Aikman. Unlike past late-stage cycles, the peak has lasted longer than typical while other characteristics of the stage, such as slower economic growth and increasing corporate bankruptcies, have yet to materialize, he says.

Watch for the markers of change

To understand when the cycle may begin to shift, there are a few key metrics to keep an eye on, says Aikman. One sign is a rise in corporate bankruptcies. Companies that have taken on debt in the early and peak stages could have trouble paying their loans back when rates rise, especially as declining consumer spending impacts profitability.

According to Statistics Canada, in 2007 – when we were last in a late-stage cycle – more than 7,000 businesses became insolvent.² As of July 2023, a little over 4,000 companies were insolvent, up 49 per cent year-over-year.³ While we never know what the future holds, Aikman, for one, expects to see more bankruptcies before we move into the early stage.

As more of the traditional traits of a late-stage cycle emerge, investors tend to gravitate toward defensive businesses that make money and pay good dividends, he says. “At the end stage of it, you’d typically see a change in allocation to defensive positions – companies that have very low levels of debt and good business models that are popular in bad times,” he explains.

Also, watch out for an official announcement of a recession. A “technical recession” is typically defined by two consecutive quarters of negative growth, however there are often other factors that come into play when determining if an economy is in recession. In September, after Canada saw negative growth in the second quarter, RBC Economics said that a “long-expected ‘mild’ economic downturn may have already begun.”⁴ As third quarter data is released, Canadians will have more information.

When the recession chatter slows and the economy starts growing again, interest rates will likely come down – though the Bank of Canada says not to expect the ultra-low rates we’ve had over the last decade.⁵ As we enter the next early-stage cycle, we may see some investors take on more risk in their portfolios, which could include small-cap stocks and other companies that benefit from a return to consumer and business spending. You could also see increased interest in technology stocks, says Aikman, especially in hotter areas of the market, such as artificial intelligence or quantum computing.

Many of the businesses that do well in an early stage are also in the value camp, according to a report from RBC Wealth Management.⁶ Value stocks are typically defined as those companies with strong business models, solid fundamentals that have seen their prices decline during the late stage and are deemed to be trading at a price relatively lower than their peers. “The (value) segment has a meaningful share of cyclical stocks in the financials, industrials, materials, and energy sectors, which are quite sensitive to changing economic trends and should benefit as the economy reopens,” wrote the authors of the RBC report.

Ultimately, the economy does tend to move in cycles, which means stronger growth may be on the horizon. What does this mean for investors? Now’s when you should pay attention to the broader economic metrics that have historically shown how the market’s moving. From there, you can find ways to position yourself for better times ahead.