In its very simplest form, the business cycle (which is also often referred to as the economic cycle or stock market cycle) simply refers to alternating periods of simultaneous expansion in economic activities, followed by a similar contraction in the same activities. This sequence is repetitive, but is not periodic, meaning that a business cycle can last from a year to more than a decade.
Certain types of investments do better in different phases of the business cycle. If you can determine roughly where in the business cycle you are, it becomes a relatively simple matter to put your money into the investment type which performs best during that phase.
For my purposes, I divide the business cycle into four phases: Early (recovery/expansion), Mid (prosperity/growth), Late (slow down), and Recession. Many models use different names and attempt to divide the cycle into additional phases, or to subdivide the phases into different stages. But the Thrift Savings Plan is simple – you only really have three choice: the broad stock market (the TSP S Fund), large capitalization stocks (the TSP C Fund), and bonds (the TSP G or F Funds) – and so the simple model is all that we need for determining how to determine our Thrift Savings Plan allocation.
I will explain in more detail below, but in a nutshell I allocate my Thrift Savings Plan funds as follows during the different phases of the business cycle:
PHASE THRIFT SAVINGS PLAN ALLOCATION
Early: TSP S Fund
Mid: TSP S Fund transitioning to TSP C Fund
Late: TSP C Fund transitioning to TSP F Fund
Recession: TSP F Fund transitioning to TSP G Fund
The Phases of the Economic Cycle:
The Early (Recovery/Expansion) Phase
Thrift Savings Plan Allocation: 100% TSP S Fund
This is the phase of the business cycle with the best performance. The broader stock market, which for us means the TSP S Fund which mirrors the Wilshire 4500 Completion Index, has produced a 24% average total return per year during this phase, and its average length has been a little more than a year (15 months). Some people will refer to the TSP S Fund as representing small capitalization stocks which is true only in a relative way because of the 4500 largest publicly traded US stocks, it represents those between places 1000 and 4500, with average value of around $1.25 billion.
This phase is characterized by rapidly improving growth, declining unemployment, low interest rates, low inflation, and improving public sentiment.
The Mid (Prosperity/Growth) Phase
Thrift Savings Plan Allocation: 100% TSP S Fund transitioning to 100% TSP C Fund. As the TSP C Fund’s monthly returns catch up to and overtake the returns of the S Fund, I will transition from 100% TSP S Fund, to 50% each TSP S Fund and TSP C Fund, and finally to 100% TSP C Fund.
This phase is typically by far the longest, averaging four years, and is characterized by strong growth, low unemployment, rising interest rates, increasing inflation, and strong public sentiment.
During this phase, economic activity is strong. Economic performance by all measurements is near its peak. Inflation starts to increase, so the Federal Reserve starts increasing interest rates in an effort to “cool down” the economy as it approaches full employment.
The Late (Slowdown) Phase
Thrift Savings Plan Allocation: 100% TSP C Fund transitioning to 50% each TSP C Fund and TSP F Fund. As leading economic indicators point towards an impending contraction I will move half of my funds to the safety of the TSP F Fund to protect them from a sudden drop, while maintaining the other half in the TSP C Fund to try to squeeze out the last of the growth in the business cycle.
If the Federal Reserve is successful in slowing the economy down, this phase is known as a “soft landing”. Ideally the economy would alternate between the growth and slowdown phases. But that usually is not what happens.
The slowdown phase has tended to last a year and a half on average, and even though things are slowing, overall stock market performance has averaged 9% on an annualized basis.
This phase is characterized by slowing growth, flat unemployment, flat interest rates, slowing inflation and increasingly negative public sentiment.
The Contraction/Recession Phase
Thrift Savings Plan Allocation: 100% TSP F Fund when interest rates are flat or falling, 100% TSP G Fund as interest rates begin to rise
If the Federal Reserve overshoots its intended soft landing, the recessionary phase or “hard landing” results. Growth is contracting, inflation tends to be lower, retail sales are weak and inventory levels are high. Corporations reduce their capacity by cutting down on workers, creating an overall higher level of unemployment. The central bank reacts by cutting interest rates.
This phase has historically been the shortest, lasting a little less than a year on average, and the broader market has performed poorly during this phase (-14% average annual return).
It is characterized by weak growth, high unemployment, falling interest rates and negative public sentiment.
In my next post (How to Determine the Current Phase of the Business Cycle) I will explain how I establish where in the business cycle the US economy is currently located through a combination of economic indicators, and what the tipping points are for changing my Thrift Savings Plan allocation.