Cycles and Sectors

Split all businesses into two temperaments. Defensives sell things people buy in good times and bad — toothpaste, medicines, electricity. Recessions barely dent them. Cyclicals sell things people postpone when times get tight — cars, homes, steel, cement, machinery. Their profits don't dip in downturns; they crater. And in booms, they don't grow; they explode.

Cyclicals carry a built-in boom-bust engine, and it's worth understanding because it never stops running. Take steel: demand rises → prices jump → steelmakers earn windfalls → everyone expands capacity and new players rush in (all borrowing heavily — Chapter 7 — because optimism is at its peak) → two years later all that new capacity floods the market at once → prices collapse → the weakest players die under their debt → capacity shrinks → shortage returns → repeat. The cycle is powered by human nature and construction lag, which is why a 100-year-old description of it still reads current.

Now the trap — one of the most reliable in all of investing. At the cycle's peak, a cyclical company shows record profits, which makes its P/E (price ÷ earnings, Chapter 11) look wonderfully cheap — precisely because the E is at a once-in-a-decade high that's about to collapse. At the cycle's bottom, profits are dismal or negative, making the P/E look horrifyingly expensive or meaningless — precisely when the recovery is nearest. For cyclicals, the P/E signal runs backwards. Cheap-looking often means peak (danger); expensive-looking often means trough (opportunity). Experienced cyclical investors therefore ignore peak earnings and ask instead: what does this company earn across a full cycle, averaged?

Sector rotation is this idea applied across the market: different sectors lead in different phases (banks and cyclicals early in recoveries; defensives holding firm in downturns). You don't need to time rotations — you need to know which temperament each holding has, and refuse to extrapolate a cyclical's best year into forever, which is exactly the error the crowd makes at every single peak.

The one-question test for any company: when the economy slows sharply, do this company's customers stop buying? The answer sorts your entire portfolio into its two temperaments in minutes.