In the 19th century, Scottish philosopher Thomas Carlyle coined economics “the dismal science”. Since then, this phrase has become a favorite of both economists and non-economists alike. Although the context behind the phrase has changed since it was first used, its current connotation is a comparison between economics and more mechanistic sciences such as physics. A physicist can model the world and, given a set of circumstances, return the outcome with a high level of certainty; in economics, not so much. While economists love to analyze troves of economic data and create complex models, their attempts to predict outcomes in the financial world are rarely correct:
“Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much.”
-Former Federal Reserve Chairman Ben Bernanke
This isn’t meant as a knock on economists; predicting the future in economics is incredibly difficult, if not impossible. One way to illustrate this difficulty is with the Butterfly Effect, a part of chaos theory. The Butterfly Effect commonly poses the question: does the flap of a butterfly’s wings in Brazil set off a tornado in Texas? In this context, an economist may be able to look at the tornado and trace the wind patterns back to the butterfly, but to identify a butterfly and determine if, when, and where a tornado will occur is a fruitless endeavor. Therefore, as an investor, it is most likely wiser to put a greater weight on the analysis conducted by economists than on their predictions. One such analysis that we believe is very useful for investors (though we will show doesn’t necessarily require the use of economists) is that of the business cycle.
The Business Cycle
Over long periods of time, economic growth can be attributed largely to increases in population, productivity, and capital. Over the past century, in the United States, these three factors have increased substantially, but growth hasn’t occurred in a straight line. In the short term the economy tends to fluctuate around this long-term growth trend in boom and bust periods known as the business cycle. Although all business cycles will progress differently, there is a fairly uniform progression between four definable stages: early, mid, late and recession. While there are a myriad of economic indicators that correspond with each cycle, we believe that it is easier to explain the cycle as a series of expectations and the optimism or pessimism surrounding them. In a recession people are pessimistic and therefore have low economic expectations, which are easily exceeded. As reality exceeds these expectations, people become more optimistic and gradually increase business activity. The economy then moves through the early and mid stages with optimism and expectations increasing along the way, until it arrives at the late stage where optimism has become so great that the expectations are no longer achievable. With the economy falling short of its expectations, people move from optimism to pessimism, decreasing business activity and ultimately causing a recession.
Business cycles are important to investors because different types of businesses behave differently during each phase of the cycle. If a savvy investor can determine which phase of the business cycle an economy currently resides in and when the cycle is shifting, they can opportunistically allocate their assets to sectors that should perform relatively better. In general, this means allocating to businesses providing necessary goods when times are bad and to businesses providing desired goods when times are good. This strategy is often referred to as sector rotation.
While this sounds wonderful in theory, we must not forgot the plight of our economists. Few would debate that a business cycle exists, but there is often a great deal of debate on what the current phase is and how long it may persist. The most confusing time of all takes place after shifts occur as it can take years to come to a consensus on the matter–far too long to meaningfully improve investment decisions. More importantly, your portfolio’s performance is dependent on the stock market and while it may be correlated to the business cycle, the two rarely move in perfect synchrony. To illustrate this we consulted The National Bureau of Economic Research (NBER), widely considered the final authority on the business cycle, which notes the following five cycles since 1980 accompanied with the official dates of the peaks and troughs. Since we are interested in the investment implications, we will also include the associated highs and lows of the S&P 500® for comparison. As useful as their data may be, the NBER wouldn’t have been very beneficial to any investor looking to capitalize on the business cycle. The market’s top occurred prior to the peak in economic activity in 3 of the past 5 cycles with an average lead time of 110 days; the market’s bottom occurred prior in 4 of the past 5 cycles but with a less astounding lead time of 12 days. Add to this an average delay of just over one year until the official announcement, and you’ll see why this isn’t a great system. To make things even worse for investors, over the same time period there were four occasions (seen below) where the stock market declined even though the economy was not in a recession. Due to this it is often said that “the stock market predicts 9 out of every 5 recessions”.
However, since our investment success ultimately depends on the movements of the market, it may be more accurate to flip this on its head and say, “recessions correspond with 5 out of every 9 market declines”. As a result, it would appear that an investor would be better off listening to the market while keeping the business cycle in mind rather than focusing solely on the business cycle.
Our tool of choice for creating an investment strategy to benefit from the business cycle will be momentum. Broadly defined, momentum investing is the process of investing in securities that have outperformed their peers over a recent time frame in hope that they will continue to do so. We extensively covered momentum in a previous paper titled “Is Momentum a Viable Strategy? Yes, but not the way you think”4 and recommend reading that as a starting point if you would like more information on the topic. Our basic premise behind this strategy is presented below:
- Certain sectors will perform relatively better than others during different stages of the business cycle.
- A momentum strategy, in this case using a moving average, can help us identify which sectors are more likely to realize positive performance going forward.
Our expectation is that a moving average strategy, which uses market data, may help us to determine which sectors are actually doing well during each portion of the business cycle. This could allow investors to benefit from the business cycle without requiring the sectors that have historically performed well during certain stages of the business cycle to do so in the future. To illustrate this point, we tested a hypothetical momentum-based strategy that would have held, in equal weight, any of the nine GICS-defined sectors of the S&P 500 that were trading above their 200-day moving average, a common metric of strength that we used as a proxy for momentum. For comparison, we also tested a hypothetical fundamental portfolio in which we took a backward-looking approach by fitting the last twenty-five years5 into one of the four cycles. Owning only the sectors which have historically outperformed the average6 in each particular cycle. Under this methodology the fundamental portfolio would have remained fully invested throughout the test period, but we recognize that this is an unfair knock on the economist. After all, we would expect the world’s best economist to know that none of the S&P’s nine sectors have achieved a positive return across our test period during recessions. Therefore, we will assume our test fundamental portfolio went to 100% cash during recessions.
On the chart above, each point represents the annualized trailing 3-year return for the test momentum and fundamental sector rotation strategies compared to that of the S&P 500. It is important to note that the analysis above does not take any expenses, taxes, management fees, or trading costs (the momentum strategy averaged roughly 69 trades per year) into account, and therefore likely overstates returns. It appears as though the test momentum-based strategy managed to mimic the results of our handpicked test fundamental strategy relatively closely across the test period. To further examine why this was the case, we examined the average holdings of the momentum-based strategy during recessionary periods in the chart to the left. The highlighted sectors are the ones which historically outperform their peers during recessions. Outside of the Materials and Energy sector, which remained in the momentum model longer during the 2007-2008 recession due to strong performance in the prior late cycle, the allocation is fairly harmonious with the fundamentals. However, by using momentum to identify when a sector “fails”, the momentum model has significantly more flexibility in raising cash and can hold on to or get back into defensive sectors when beneficial during a recession. This difference is glaring when looking at the early 2000s tech bubble when the S&P 500 failed as a leading indicator. After the official end of the recession it declined an additional 27%. The fundamental model was forced to suffer through this, while the momentum model could react defensively and raise cash outside of an official recession.
This flexibility is incredibly important because in addition to the inherent delay of a fundamentally-driven business cycle strategy, the fundamental strategy also assumes that the relationships between certain sectors and certain stages of the business cycle, which existed in the past, will continue to exist in the future. It is logical to believe that businesses providing necessary goods will perform better on a relative basis when times are bad, and businesses providing desired goods will perform better on a relative basis when times are good. However, businesses and economies evolve.
As technology progresses and businesses adapt accordingly, the composition of sectors may become increasingly blurred. For example, is the ride-sharing phenomenon UBER, a transportation company, placing it in the industrials sector, or should its heavy dependence on technology and low overhead place it in the Technology sector? What about Amazon? Is the online retailer more comparable to a consumer discretionary company, a consumer staples company, or a technology company? While it currently resides in the Technology sector, it’s clear that a case could be made for all three. In addition, the effects of globalization further complicate how we define the business cycle as companies increasingly derive more of their sales outside of the United States. In the four sectors which generated over 50% of 2014 sales outside the US8 do we need a full assessment of the international business cycle as well to determine how they will be affected?
We don’t have the answers to these questions, but by taking advantage of a market phenomenon such as momentum, we can react to the changing market fundamentals without the impossible burden of predicting them.
Copyright © 2015 Beaumont Financial Partners, LLC. All rights reserved.
Includes equity market returns from 1962 through 2010. Returns are represented by the top 3000 U.S. stocks ranked by market capitalization. Sectors as defined by GICS. Source: Fidelity Investments (AART) as of Apr. 30, 2012. Early Cycle: Above average acceleration in economic activity. Macroeconomic variables rebound from previous contractionary phase; Mid Cycle: Rate of growth in economy is positive but not increasing at the rate of the previous Early-Cycle phase. Overall growth is peaking and economy is generally healthy; Late Cycle: Growth remains positive but is slowing, inflationary pressures begin to build; Recession: Contraction in economic activity, profits decline and credit is not readily available.
National Bureau of Economic Research business cycle peak and trough dates: US Business Cycle Expansions and Contractions. (2010, September 20). Retrieved August 19, 2015, from http://www.nber.org/cycles.html
S&P 500 peak and trough dates were determined using the S&P 500 Total Return Index produced by Standard & Poor’s Financial Services LLC.
S&P 500 Index returns retrieved from Bloomberg. Recession dates retrieved from the National Bureau of Economic Research, as cited in endnote number three. 1-Year rolling return was calculated as the 252 trading days preceding each date.
Rezendes, D., & Ryan, B. (2015). Is Momentum a Viable Investment Strategy? Yes, but not the way you think. Beaumont Capital Management. Please contact firstname.lastname@example.org to request a copy of this paper.
Global Industry Classification Standard (GICS) taxonomy is utilized in the construction of the Standard & Poor’s sector indices. Classification for United States corporations begin in 1989 and as a result sector index data is only available in periods following 1989.
Composition of fundamental strategy in each stage is an equal weighted portfolio of the following sectors. Early Cycle: Materials, Technology, Financials, Consumer Discretionary, and Industrials; Mid Cycle: Technology, Healthcare, Financials, Energy, and Industrials; Late Cycle: Materials, Healthcare, Consumer Staples, Utilities, Energy; Recession: No sectors held.