What to avoid at the peak of the business cycle?

February 11th, 2007

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In our last article, Where are we in the business cycle?, we mentioned that we are now probably at the peak of the business cycle. Given that this is the case, how should that affect our investment decisions?

In Peter Lynch?s book, Beating the Street, he wrote:

When the economy is in the doldrums, the professional money manager begins to think about investing in the cyclicals. The rise and fall of the aluminiums, steels, paper producers, auto manufacturers, chemicals, and airlines from boom to recession and back again is a well-known pattern, as reliable as the seasons.

Therefore, cyclical stocks are the ones in which their earnings follow along with the peaks and troughs of the business cycle.

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ?cheap? (i.e. low P/E ratio) during the peak of the boom. This is because the market will have by then factored in the fall in earnings. The key is to identify which types of businesses are cyclical in nature and avoid them during the peaks? turning point. As Peter Lynch said:

When the P/E ratios of cyclical companies are very low, it?s usually a sign that they are at the end of a prosperous interlude. Unwary investors are holding on to their cyclicals because business is still good and the companies continue to show high earnings, but this will soon change. Smart investors are already selling their shares to avoid the rush.

In Australia, the economy has been expanding for the past 16 years already. This current expansion is twice as long as the previous two expansions. Thus, it is very easy for investors to believe that business cycles no longer apply and become complacent as a result. When we see that the stock market is continuously making record highs, as if the boom time will still continue indefinitely, it is time to become wary.

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