EPB Macro Research
The most important determining factor for the return profile of various assets and equity sectors is the direction of the economic cycle. Is the economic cycle trending higher or trending lower?
When the global economic cycle is trending higher, high beta sectors dramatically outperform, long-duration fixed income suffers and equity volatility is generally lower than average. This is a great time to be long of cyclical equity sectors.
Conversely and unsurprisingly, when the global economic cycle is trending lower, a "down cycle," cyclical equity sectors suffer large declines, defensive equity sectors greatly outperform, long-duration fixed income generally rises and equity volatility or "market events" are an active risk.
Since the start of 2018, the global economic cycle has been in a "down cycle" which explains the dispersion in sector performance, the decline in interest rates and the constant volatility in equities including the "market event" in December 2018 which is highly consistent with down cycles throughout history.
Below I will outline the research to support these claims in a study I collaborated on with Teddy Vallee of Pervalle Global. You can find Teddy on Twitter at (@TeddyVallee)
Identifying Growth Cycles
The first part of this analysis is defining up cycles and down cycles. We use a signaling process including the length of the decline/rise, the magnitude and the breadth of the move to define the peaks and troughs.
In the chart of the Global PMI below, we identified seven up cycles and eight down cycles, the eight which is currently still underway.
Down cycles are defined by moves in the chart below from A to B while up cycles are defined as moves from B to A.
Once the growth cycles were defined, we tested the average and median performance of various equity sectors, fixed income positions, currencies, commodities and more.
In roughly 22 years, there were only 15 major portfolio pivots that you needed to make to achieve the best returns, minimize drawdowns by positioning in the correct sectors and beat the averages.
Historically, major portfolio pivots only occured every 1.5 years with some pivots lasting well over two years, far from a short-term strategy and quite reasonable even for long-term 401k investors, long-only investors or tactical long/short asset managers.
I will present some of the data below.
Performance Dispersion - The Cycle Is Critical
The tables presented below highlight the start date of each up cycle and down cycle as well as the duration, the return per week, return per month and full-cycle return. The average and median for each category is also presented.
For the S&P 500 (SPY), the cycle is absolutely critical when it comes to the return profile. During up cycles, which lasted an average of 1.3 years, the average return is over 25%. Conversely, the down cycle, which lasts an average of 1.62 years carries an average performance of -6.44%.
Currently, the global economy remains in a down cycle, which based on various leading economic indicators used to forecast the direction in the domestic and global economy, is set to continue through year-end. It is highly possible to have a positive S&P 500 return in a down cycle, something we are currently witnessing although this current regime has not concluded.
The analysis gets more interesting when we dig into the sector-level performance.
Utilities have been the best-performing equity sector since January 2018 despite overwhelming criticism about valuation and commentary regarding a general "crowded" trade, but the historical analysis shows that Utilities (XLU) are in fact nearly always a top-performing sector during a down cycle.
Utilities dramatically underperform the broader market during up cycles, carrying an average return of just 4.34% while boasting a positive return north of 7% during down cycles while the broader market typically falters.
One portfolio allocation decision you can make during down cycles, if you prefer to hold equities, is to shift towards an overweight balance in Utilities and other defensive equity sectors that tend to outperform.
The second key to investing through a down cycle is to underweight, avoid, or short cyclical sectors.
Financials (XLF), on average, outperform the broad market during up cycles but nearly double the average losses during down cycles.
As I will outline in a section at the end of this note, financials have been a major laggard since the start of 2018 (or the start of the current down cycle) which is again, perfectly consistent with history.
Avoiding financials during down cycles, which we are likely to remain in through the balance of 2019 based on long and short leading economic indicators remains a prudent decision.
One of the most cyclical sectors, industrials, as you might expect, outperforms during up cycles and falters during down cycles.
We have tested nearly every equity sector, various currencies, fixed income, commodities and more through various up cycles and down cycles and use this information in making portfolio allocation decisions.
The data above, which is only a slice of the total results, reinforce why it has been a good decision to stay long of defensive equity sectors, high quality fixed income such as US Treasuries (TLT) and relatively high yielding cash while avoiding or staying short of financials, industrials, and cyclical sectors more broadly.
Current Market Performance - Does It Make Sense?
Identifying a decelerating rate of economic growth does not translate to a bearish view on the broader equity market. I personally have not shorted the S&P 500 and actually, hold a long yet underweight allocation in SPY.
The analysis of equity sector performance, however, nearly perfectly aligns with the historical analysis during down cycles.
The massive decline in interest rates, radical outperformance of Utilities, the negative return in Financials and Regional Banks (KRE) are all historically consistent with a second derivative slowdown in economic growth.
"Market events" such as December 2018 are also highly common and an ongoing active risk during down cycles.
With the current down cycle still underway, a "market event" or large correction remains an active risk.
Drawdowns are significantly diminished during up cycles.
Adding An Inflation Kicker?
An analysis that I worked on individually added an inflation component to the equation and the results were highly similar. The order of sector performance during up cycles and down cycles remained consistent with the analysis above although the magnitude was amplified when combined with rising or falling inflation.
The analysis below shows the average monthly excess return over the S&P 500 for each sector during a down cycle (growth decelerating) and also when inflation expectations were trending lower, as they currently are today.
Utilities remain a top performer as does long-duration fixed income. Banks, energy and transportation stocks lag.
With economic growth still currently in an empirically observable down cycle and inflation expectations trending lower in Europe and the United States defined by breakeven rates, sector dispersion is likely to remain large.
How You Can Spot These Trends Using Leading Indicators
Having the analysis of which sectors to overweight and underweight during each regime of growth and inflation is only one, yet a critical, step.
Equally or if not more important is having a leading indicator process to forecast the direction of the global and domestic economic cycle.
Using a series of long leading indicators, confirmed by moves in short leading indicators, we have early warning signs of when the cycle is going to inflect positively or negatively.
These economic inflection points are where most investors get caught offsides in the wrong sectors or asset classes and therefore suffer the largest drawdowns or periods of relative underperformance.
If you are a macro-based investor, having a leading indicator approach coupled with the analysis of relative performance during up cycles and down cycles will allow you to significantly increase your chances of being positioned in the best sectors while avoiding the laggards.
401k investors will be alerted when to shift assets or reduce exposure to stock funds in favor of bond funds.
Even if you are an individual stock picker, your hit rate, or probability of success will be increased dramatically by identifying the correct sectors from a macro standpoint, based on the trending cycle, and narrowing your basket of stocks to select from.
Having a process that involves long leading, short leading and coincident economic data, coupled with the historical sectoral analysis during each cycle of growth and inflation will help to dramatically improve your investing results.