Markets go up, markets go down. Get your timing right and you’re in the money. Wa-hey!

But if you’re good at getting the main market direction right, have you considered that you can make oh so much more by trading individual shares than trading the index. For example, if you’d opened a short bet in FTSE last July (and resisted the temptation to close it) you’d have made around 16%. But if instead of that you’d sold HBOS your return would be 74%; on Barratt Development you’d be 90% better off. So, if you prefer caviar to custard and Barbados to Butlins read on and find out how you can get some ‘value-added’ from your trading.

Today folks, we’re going to look at aggressive and defensive investments. Fund managers use this thinking to protect their share portfolios during the tough times and to get more bang for their buck when markets are flying. What we’re looking at here is to try and identify the best times to trade certain stocks and how best to play the economic cycle. Part 1 of this two-parter will look at equities and how knowing when to trade different sectors will put more notes in your back pocket. Part 2 in a couple of weeks will look at using non-equity bets to ride the economic cycle.

Just Nipping Back To The Classroom
Here’s a 30-second refresher on the economic cycle for newbies:
During the recovery phase companies borrow at low interest rates to expand the business. This creates more jobs and people in general start to feel better off. This encourages people to move up the property ladder, or to stay put and spend on home improvements or flat-screen TVs. As firms struggle to produce enough houses/ plasma screens/ hummers to meet consumer demand they employ more workers, eventually having to pay higher wages to attract workers from other firms.

At some point inflation will rear its ugly head and the central bank will call an end to the fun and games by raising interest rates. The cycle then goes into reverse; as rates rise people have less money to spend on ipods and Coleen Rooney handbags. Buying a bigger house that’s going to cost more loses its appeal, especially with the increasing prospect of unemployment. Firms react to lower sales by cutting staff who in turn spend less, blah, blah, blah. If you want to read up more on inflation here’s some of our earlier articles:

MCP, PC OR MPC? Inflation Explained
Loan Sharks In Expensive Suits
More Cred Than The Fed

So What’re We Looking At?
The trick now is to apply the economic cycle to the stockmarket cycle. Most of it is pretty obvious stuff, but I find sticking things on a chart makes it easier. Luckily I found just the thing at MarketOracle:

The first thing to note is that the stockmarket travels in a Bugati whereas the economy uses public transport. Or put another way, by the time we recognise where in the economic cycle we are the stockmarket has already been there and moved on (the stock market normally leads the economic or business cycle by 6-9 months).

The second thing is that the numbers show where sectors are bought, but not where they’re sold. So, for example, when things look really bad, and even the BBC news is talking recession, investors will be looking to buy into financials and consumer cyclicals.

Bets With Attitude
Aggressive investments, as they’re known, are those most sensitive to changes in the economy. They’re most likely to suffer in a slowdown, and consequently more likely to benefit if we think the sun is rising on the economy again. Their earnings are closely linked to the feel-good factor and expansion in the economy.

Plenty Of Interest In Banks
Banks are one of the first in the firing line; the majority of their business, borrowing and saving, is interest rate sensitive. The recovery phase sees firms keen to borrow to expand their business, followed by consumer loans as confidence increases in the economy. So, with the hefty percentage they make on each loan, that’s a pretty quick caffeine shot to the banks’ earnings.

But once the economy turns banks are first in the firing line. Business drops off as people (and firms) are less likely to borrow money for the right reasons; they borrow because they need to, not because they want to. What’s that old banking saying, “If you need to borrow from us, we’re definitely not going to lend to you.”

Secondly, banks lose money from existing loans that can no longer be repaid. The term is ‘bad debt provisions’, where banks take a hit on loans and mortgages that are unlikely to be repaid. It’s been HBOS and Bradford & Bingley’s exposure to the UK mortgage and Buy To Let market that’s seen their share prices destroyed over the past year.

Building A Better Future
Hey, have a look at your monthly mortgage payment. Fancy moving up the housing ladder? Along with petrol, buying a house is probably our biggest purchase, and not many of us can do it without a very big, very long mortgage. So when interest rates (and therefore mortgage payments) start to rise the house builders suffer big time. But these firms don’t only have hundreds of houses on their books; they’ve built up land banks (fields with planning permission), to accommodate their building programmes. But they can’t react quickly when the music stops, and end up with towns of unsold houses just when the housing market turns.

On the positive side, house builders’ shares usually get so smashed in a downturn that they’re attractive once the cycle is seen to be turning.

Buying Into The Recovery
Retailers are historically split into cyclicals and non-cyclicals, though at times that distinction has become pretty blurred. Non-cyclicals are the supermarket types (the ones that sell Weetabix and toilet paper, and continue to do so regardless of how well off we are). However, many of these have become more cyclical through their expansion into electrical goods, garden furniture and home gym equipment.

But it’s the true cyclicals, like DSG (Dixons and Comet), Home Retail, Land of Leather and Kingfisher (B&Q) that are such sensitive creatures. Retail firms benefit from the recovery in several ways:

1) After buying your house what’s the next thing you do? OK, after e-mailing your new address and popping down the pub to celebrate with your mates. Certainly your missus is likely to want to fill every available space with new carpets, furniture, and all those strange white boxes that fit in the kitchen.

2) If you’re not moving house, but notice more money in your wallet each month there’s a fair chance you’ll be loading up with the latest boys toys (plasma tellys, ipods) while she’ll be acting out Sex In The City by buying more shoes.

3) It could be that you don’t fancy moving, but can’t believe how much the value of your house is rising. Hey, why not take out a bigger mortgage and buy that conservatory/ SUV/ ticket for next year’s Lions tour that you’ve always wanted?

When the economy turns, picture all these things slowing down a lot and retailers with no Plan B.

Companies With No Interest In Rates
Defensive companies are those whose earnings are less responsive to changes in the economy. They’re firms that provide goods or services that we’re still going to need even when we’re not feeling quite so wedged-up.

Utility companies are classic defensive stocks. How often does your missus say, “We’re in the middle of an economic slowdown; let’s turn the telly off and sit in the dark for a while.” Well ok, apart from when the snooker’s on. Not only do utility companies have a monopoly on things we need, but they’ve got permission to keep putting their prices up. So their earnings are pretty damn safe.

Pharmaceutical/ Healthcare companies aren’t quite monopolies, but the same arguments apply. If you’re suffering with a dodgy tummy or in need of some instant protection, you probably couldn’t give a rat’s arse about the prospect of a lower salary increase next spring. People don’t stop being ill during an economic slowdown. And like the utilities, drug companies have the protection of a captive market, the NHS with its budget running into billions.

One curious one, but a very top fund manager swears by it, is the tobacco sector. Check it out on the telly; whenever you see someone being interviewed about how hard up they are they’ve got a Sky satellite dish on the wall and a fag in their hand. Being skint doesn’t stop them smoking. In fact they probably smoke more because of the worry.

We Can Swing Both Ways
This is another time when spread betters hit the jackpot. Investors in shares are hampered; they’re restricted to buying defensive shares if they’re bearish and aggressive shares if they’re bullish. But we’re laughing cos we can sell aggressive shares if we’re bearish (think back to the HBOS and Barratt examples). For more on shorting the market check out Get Shorty.

What About Now?
We know that both the UK and Ireland are knee deep in the brown, smelly stuff. Usually, a slowdown goes hand in hand with low inflation. But this time around we’ve got something called stagflation (if you’re wondering what the hell that is check out Dr Who Meets The Stagflation Monster). So defensive stocks need to address slowing growth but also rising prices. Now I’m not an equity expert, but I reckon utilities fit that particular bill.

The obvious shares to short have already been hammered. Where are we in the cycle? I haven’t got a Scooby Doo, but I’m pretty damn certain we’re nowhere near the recovery stage and could only just be entering the nasty bit. Certainly if you believe the more extreme opinions from some of the investment banks we’re still a few hundred points overweight on the main equity indexes. I definitely reckon the housing market has further to fall and soon there won’t be much spending money left after a tank of petrol. Capital raising by banks is continuing fast and furious. So perhaps the usual suspects (banks, builders, retailers) are still the jockeys’ favourites for another leg down.