Mad Money

Trading the Business Cycle

Fifty percent of a stock’s move depends on sector performance, Cramer says. That’s because most of Wall Street’s money managers take a sector-based approach to investing, and these guys buy and sell at such a high volume that they set market prices. If you can predict where the sector’s going, or where this money will flow, then you’ve all but banked half your profits before even starting.

To do this, you have understand the business cycle as well as what stocks work at certain points during that cycle. The stocks break down into two groups: secular and cyclical. The first group, secular, consists of companies whose performance is independent of the economy. Think Procter & Gamble , Kellogg, Johnson & Johnson. You don’t stop buying Band-Aids during a recession, do you? Do you stop eating? That’s why these stocks work during a downturn.

Follow the Cycle

Cyclicals, on the other hand, depend on a strong economy. These are the industrials, autos, raw-materials, consumer-durables and heavy-equipment companies. They’re great when business is booming. But when it’s not, these stocks get hit the hardest.

The key here is to buy secular stocks at the top of the cycle, just before the market’s about to turn down. It could be a global financial crisis, a bubble of some kind, higher interest rates thanks to the Federal Reserve, that kind of thing. But at the point, these plays won’t yet be in favor. That happens at the bottom. So buy them before that happens when they’re cheap. At the bottom, though, you want to buy the cyclical stocks. Try to anticipate the same kind of switch in the market you did with the secular names. When you expect the market to turn up, buy the cyclicals. They’ll ramp up as the economy does.

These cyclical stocks will look expensive, at least on a price-to-earnings basis, when the economy’s at its lowest. But that’s because analysts will have cut estimates so much that the group’s respective P/E ratios, inevitably, will have increased. If the earnings (E) estimates drop, but the price (P) stays the same, then simple math dictates a higher multiple (M). E x M = P. But just remember that those earnings will rebound as business increases.

This is a counterintuitive strategy for that reason. Usually you avoid “expensive” stocks. But knowing that a change in earnings is coming will help you see past the multiple. You might be surprised by how few people take this into account. And that, Cramer says, is why this strategy works.

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Jim's charitable trust owns Procter & Gamble.

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