cyclical and secular

The rhythmic cyclical economic progression from recession to expansion and back again affects everything the global economy.  Yes, there are sectors like Materials that go through their own long boom and bust cycles that can last decades.  There are also public Utilities that supply water or electricity that are well-insulated from cyclical fluctuations.

Despite these (relatively minor, in my view) complications, it’s useful for stock market investors to distinguish between companies whose profits are linked mostly to the business cycle–say,  a cement plant, or a supermarket or a department store–and those whose success is more a product of their own innovation or of being positioned in the slipstream of structural change–like Apple, or Amazon or Facebook are/have been.

How so?

In the simplest terms, the first group does particularly well as economic recovery springs out of recession. The latter typically begin to come into their own a year or two into an economic/stock market upswing, when demand pent up by recessionary fears is satisfied and economies settle into a slower, more sustainable growth pace.  In the case of the Great Recession, this process has taken a much longer time.

At some point, central banks step in to raise interest rates, reining in growth a bit further, and tipping the scales a bit more toward secular growth.

Yes, but…

By these last few keystrokes, the “yes, but”s have begun screaming loudly enough in my head to interrupt my train of thought.

They see where this post is going–how should we structure our portfolios to deal with the coming rise in interest rates in the US?–and the answer is going to be to go with structural growth over cyclical growth.

It isn’t necessarily that simple…

…what if the current slowdown in the US is all about the cold weather and port congestion, and we’ll get catchup in the summer?

–what about the weakening dollar, which is giving more evidence of having peaked against the euro?

–what about the EU picking itself up off the economic floor for the first time in years?

–what if the anti-corruption drive in China is past its worst and growth will pick up there?

–what about the bounceback in oil prices?

–how much do valuations matter?

…or is it?

What I think:

Rising interest rates always have a sobering effect on investors.  It’s a change to a more conservative mindset, rather than a precise calculation of the effect on profits of higher rates.

Valuations matter more than before, especially for smaller, non-mainstream companies.  Investors will take a harsher look at highly indebted companies that are struggling.  The same for startups with little more than a business plan and a prayer–it will be much harder than it is today for them to go public.  PE multiples generally don’t expand; if anything, they contract.  At the very least, investors will take pruning shears to the highest numbers.

To the degree that the US economy remains in low gear, interest in secular growth names will intensify.  However, I also think investors will lose their taste for “me too” smaller stocks.

More tomorrow.