You Can Fight The Fed, But You Can't Fight The Cycle

Is buy and hold the right strategy? When the economy turns lower, do you have to suffer through 40% losses in order to adhere to the Buffett disciples suggesting to just keep buying stocks? These are some of the most common questions investors ask on a daily basis.

Is buy and hold the right strategy? When the economy turns lower, do you have to suffer through 40% losses in order to adhere to the Buffett disciples suggesting to just keep buying stocks? These are some of the most common questions investors ask on a daily basis.

With the Federal Reserve and monetary policy in focus, these questions have taken the form of popular investing clichés such as "you can't fight the Fed."

This is a repackaged form of advice to stay in the market because you cannot time it. When the Fed is raising rates, the economy is doing well so equities and bank stocks are a great bet. When the Fed is lowering rates, despite the weaker economy, the lower rates will be fuel for equity prices. Sound familiar?

The truth of the matter is that the Fed doesn't matter. You can absolutely fight the Fed or allocate your portfolio in the opposite direction of their monetary policy and in fact, you should. You just cannot fight the economic cycle. You must use the economic cycle to your advantage and as a tailwind in order to outperform over decades of investing.

Using the predictable rhythm of the economic cycle, there is a better and far less volatile way to navigate the chop.

Using Economic Cycles

In a recent note on why cycles matter, which you can read by clicking here, I highlighted seven "up cycles" and seven "down cycles," the seventh which we are currently still in as outlined by the data below.

The cycles, defined using several factors such as the length of the decline, the magnitude of the decline and the breadth (the number of components declining) of the decline are outlined in the chart below. Down cycles are from points A to B and up cycles are from points B to A.

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Source: Bloomberg, EPB Macro Research

We can test the performance of various assets as we did in the previous research note during each up cycle and each down cycle. The results are overwhelmingly clear.

During up cycles, the average return for the S&P 500 (SPY) is over 25% while the average return during down cycles -6.3%.

Buy and hold investors don't often realize that virtually all of their gains over time come during up cycles and down cycles simply lower the total return over a lifetime of investing due to recessions, growth-scare induced drawdowns, and volatile markets. You could be using both up cycles and down cycles to your advantage.

It is not uncommon for the S&P 500 to rise during a down cycle as it currently stands with a gain just north of 6% since the latest cyclical inflection point. The cycle is not over, however, which means the classic down cycle risk remains and there are other investments that may be more prudent.

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Source: Bloomberg, EPB Macro Research

The return of Treasury bills during up cycles and down cycles is presented below and the return profile is extremely stable as you'd expect. The average return during a down cycle exceeds the S&P 500 by over 10% and there are some cycles in which you could have achieved a greater than 40% outperformance by shifting to Treasury bills during a down cycle vs. staying invested in the S&P 500 or worse, cyclical equity sectors.

There are some cycles, such as 2014, in which you would have earned just 0.3% in T-bills vs. a gain of +4.7% in the S&P 500. This kind of underperformance, or fear of missing a large equity rally, prevents most investors from using the economic cycle to their advance over a lifetime of investing, even when the results are clear.

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If we look at the return profile of 30-year Treasury bonds across up cycles and down cycles, the results are stunning. When the economy is accelerating, Treasury bonds decline as you'd expect.

During down cycles, when growth is in a phase of deceleration, Treasury bonds soar with an average full cycle return of +24.5%, greater than 30% better than the S&P 500 during down cycles.

In some cycles, such as the 2006 down cycle which ended in a recession, you would have achieved a greater than 76% outperformance had you shifted your allocation to long bonds (TLT) rather than holding the S&P 500 and suffering one of the worst declines in decades.

While the gains in the stock market from the bottom in 2009 look compelling, it took years to get back to breakeven before your compounding resumed had you suffered the peak to trough drawdown of the S&P 500 as many investors did.

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Source: Bloomberg, EPB Macro Research

Using the economic cycle, you could massively outperform the broader market and end up with three, four or five times more money by using both up cycles and down cycles to your advantage.

The true beauty of using economic cycles is that they are long-lasting so every type of investor can benefit from the economy's predictable rhythm.

Short-term growth rate cycles, not to be confused with business cycles, don't last a few days or a few months, they last several quarters or 1.5 years on average so there is no need to shift your allocation on a frequent basis.

Shifting your portfolio mix every two years is far from a high-frequency trader and something that even long-term 401k investors can apply to their investing strategy.

Using the cyclical turning points defined in the tables above, we can look at the total return of investing in the S&P 500 or investing in the S&P 500 during up cycles and shifting to T-bills during down cycles.

Consistent with the tables above, we know virtually all gains come during up cycles and the two ~30% drawdowns kill your long-term compounding.

You would have virtually doubled your ending balance had you used the economic cycle to your advantage and just shifted to T-bills during down cycles.

Outperforming by 40% in some cycles adds up over time.

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The problem, however, is that in some down cycles, the S&P 500 rises and you feel stupid for sitting in boring T-bills while the masses are still riding the S&P 500. This is the current situation we find ourselves in today. The economy is in a down cycle and cyclical equity sectors are performing poorly since the January 2018 inflection and bonds are rising yet the S&P 500 has a positive return.

Although this is highly consistent with the historical analysis, if you are investing according to cycles, in this down cycle, it is tough to look at a positive return in the S&P 500 as anything other than "wrong" even though bonds are outperforming and defensive equity sectors are rising more than cyclical equity sectors.

Had you used the economic cycle and even loosely called the turning points, you would have wildly outperformed your peers and benchmark and you wouldn't be anxious about the 5%-10% current return in the S&P 500 during this down cycle (which came with a 10% and 20% drawdown). More likely, you'd be happily waiting in T-bills (collecting the highest yield of the cycle), long-term Treasury bonds (which have outperformed stocks this down cycle), or even defensive equity sectors while the majority of investors stay invested, assuming all the risk that comes with a down cycle (corrections, recession, etc.)

These following allocations are not to imply a "black box" strategy of perfectly shifting your allocation but rather to highlight the massive outperformance possible if you use the economic cycle to your advantage over a lifetime of investing.

Some investors have a long-only mandate and have to remain fully invested. If you fall into this camp, you can still use the economic cycle to your advantage.

Below is a test that looks at buying the S&P 500 or buying an equal-weighted "cyclical basket" during up cycles and an equal-weighted "defensive basket" during down cycles.

The cyclical basket is an average of the financials (XLF), industrials (XLI) and materials (XLB) sectors. The defensive basket is an equal-weighted average of the utilities (XLU), consumer staples (XLP) and healthcare (XLV) sectors - your common "defensive sectors."

This strategy is long stocks all the time but aggressive during up cycles and defensive during down cycles - a logical approach, right?

This approach outperforms wildly yet some investors, pundits and talking heads are banging the table on cyclical sectors during this current down cycle, fighting the cycle, the biggest mistake you can make.

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The data is so clear that after conceding the point that cycles are the most important factor across your entire investing career, the logical objection revolves around an inability or a lack of belief that cyclical turning points can be forecast with any degree of accuracy.

The good news is that we are not timing the markets but rather the predictable rhythm of the economic cycle which you can undoubtedly forecast.

Forecasting economic inflection points can be done by monitoring baskets of economic data that both logically lead in the economic sequence and have empirically led the economic cycle throughout history.

At EPB Macro Research, in addition to studying secular economic trends and business cycle trends, we are hyper-focused on the short-term growth rate cycle or the 12-36 month fluctuations in growth that drive the majority of your investing returns.

When analyzing these shorter-term cycles, we use a combination/confirmation process of several leading indicators, separated into two baskets: longer leading data and shorter leading data.

Longer leading data turns as much as 12-18 months before cycle turning points, followed by shorter leading data with moves that can be 6-8 months before downturns and 3-4 months prior to upturns.

By measuring long leading data, and having it confirmed by short-leading data, a high level of conviction can be gained before a cycle turning point and a pivot in asset allocation.

The long leading indicator graphed below, one of several long leads we use, outlined this current down cycle over 12 months in advance of its inflection point.

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After the long leading indicator has inflected, we then start to get hyper-focused on a variety of shorter leading indicators that turn next in the sequence.

Below is a shorter leading index of the US ISM manufacturing PMI.

As both charts show, without a sufficient upturn in either the long leading indexes and without confirmation in shorter leading data, the call for this economic "down cycle" remains and the allocation to defensive sectors over cyclical sectors and bonds over stocks remains firmly intact.

Even if this is one of the few down cycles in which a defensive posture underperforms the broader market, which is possible throughout history as outlined earlier in this note, the most important part of the down cycle is not to suffer a large drawdown.

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At EPB Macro Research, once an inflection in longer leading data is identified, which is then confirmed by shorter leading data, a cyclical turning point is declared and the allocation shifts to stocks over bonds and cyclicals over defensives.

Let's say you still don't believe you can time cycles and the combination/confirmation process of longer leading data and shorter leading data fails at a turning point.

What would happen to the results if we shifted the cyclical turning points three months late at all 14 inflection points?

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If you invested in the S&P 500 or the S&P 500 during up cycles and 30-year bonds during down cycles but were three months late at each inflection, essentially just using the widely available PMI data sets, the outperformance is still staggering.

The reason that the outperformance is so dramatic is the complete avoidance of two ~30% declines that were replaced with 35% and 46% gains in the long-bond.

Cycles are critical. You may be invested in a sector that is a land mine without knowing it and this is where the problem lies - not being a few weeks late to the turning point.

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Sticking with the original turning point dates outlined in the tables first presented, a system of buying the S&P 500 during up cycles and 30-year bonds during down cycles resulted in 5.7x more money from 1998-2019.

You can fight the Fed - you just can't fight the cycle.

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It is common to have a fear of missing out on an equity market rally. During a down cycle, the broad market can still rise which sucks in many investors without regard for the risk of the cycle. There are assets that rise with regularity during down cycles so there is no fear of missing out.

The easiest way to use the leading indicator process is to be long of cyclical equities during up cycles and shift to overweight bonds and defensive equities during down cycles. It also makes logical sense and can be done in both tactical accounts and your more long-only passive accounts. Aggressive during up cycles and defensive during down cycles.

Knowing the economic cycle, which you will virtually all the time with a combination of long-leading and short-leading indicators, is the biggest tailwind to have at your back when making investment decisions.

Even without the leading indicators, if you just followed the PMI data above and were a month or two late at each turn, you still would have amplified your investment returns to dramatic effect.

Knowing the direction of the economic cycle is the best way to maximize your upside and minimize your downside risk. The biggest risk to your portfolio always happens when you are on the wrong side of the cycle.

Using cycles is critical. Investing in safe Treasury bills is not going to destroy your long-term returns. Investing in sectors with cycle risk during down cycles is what can potentially cause the third 30% drawdown in the last three decades.

Start Using The Economic Cycle To Your Advantage

If you understand the economic cycle, you can profit from the opportunities that emerge from its ebb and flow.

With a membership to EPB Macro Research, you will understand where to put your money and when to move it in virtually all stages of the economic cycle.

Take advantage of the 14-day free trial before the price increase next week.

You have nothing to lose by joining for free but if you learn how to navigate the economic cycle, it will change the way you invest forever.

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