Despite the fact that we continue to see signs of an improving market, much of the economic data still looks troubling, and hence many investors remain quite bearish. Contrary to conventional thinking, we see this as a bullish development because we focus on the rate of change of economic data, not just the level itself.
History tells us that capital markets are a leading economic indicator since they normally recover from recessionary levels before the overall economy does. In this depiction of a theoretical business cycle (below), we see six major stages.#1 The performance of major asset classes (bonds, stocks, commodities/inflationary sensitive securities, and cash) usually depends upon which stage of the cycle we are in.
Contractions consist of Stages 1 – 3 and last 14 months on average. Bonds initially do well as stocks start to sell off due to falling estimates of corporate earnings. The Federal Reserve normally lowers interest rates during Stage 1 and early in Stage 2 to provide monetary stimulus in anticipation of a recession. Near the bottom of the economic cycle in Stage 2, fiscal stimulus normally arrives from the government, and stocks start to turn upward and outperform bonds as the market looks forward to rising earnings helped by lower interest rates. In Stage 3, inflation-sensitive securities such as commodities start to recover as do expectations for future economic growth.
Expansions consist of Stages 4 – 6 and last 44 months on average. In Stage 4, the Federal Reserve becomes concerned over runaway inflation and starts to raise interest rates, thus hurting the performance of bonds as Treasury Yield Curves start to flatten. In Stage 5, both bonds and stocks start to sell off as economic growth starts to peak, and here we often see an Inverted Treasury Yield Curve. In Stage 6, cash is the one asset class that typically outperforms, and this action then lays the foundation to repeat the cycle.
The purpose of this discussion is not to argue that we have a magic crystal ball that tells us exactly where we are in the business cycle.
First, every expansion/recession cycle is different than previous ones, so the cycle does not always work like a precision Swiss-made watch. Some recessions are caused by financial crises; others are caused by external shocks like wars, energy shortages, and even pandemics. Some recessions are country-specific, while others are global or regional in nature.
Second, actions by market participants can vary widely, and some responses by policymakers can be aggressive, while others can be slow and ineffective.
I presented this Investor Sentiment Cycle in our Weekly Wire on March 16, one week before the stock market bottomed on March 23. If this bottom holds, it is very likely that the economy has already made the transition to Stage 2 and is preparing for Stage 3. We are even starting to see the price of crude oil starting to turn up, which lends credence to a Stage 3 recovery.
We want our clients to understand that buying risky assets may not make you feel very confident at certain times in the cycle, but it is crucial to realize that maximum expected returns come from buying assets when they are priced for the most challenging times.
The financial media is not helpful when they cry that markets are crashing, so we should be afraid. Instead, we should think that risky assets are on sale and that expected future returns are higher, so buying a diversified mix of asset classes makes sense for a long-term investor. We don’t recommend this strategy with individual stocks because companies can go bankrupt and ruin equity investors. Investing in asset classes, each with thousands of stocks greatly reduces this possibility.
- Rebalancing your portfolio is an important tool we use to restore your allocation to its target by selling overpriced securities like bonds and buying underpriced securities like stocks.
- Diversification is another important tool that allows us to spread the risk around in your portfolio so that you are not making a big bet at a poor time.
- Dollar-cost averaging is another time-tested way to spread out the risk that the economy may backslide into another decline if sufficient stimulus is not forthcoming.
- Cash reserves mean you have the liquidity to weather a tough recession and put money to work in the markets when prices are cheaper.
We don’t know the future, but a study of past market cycles can help frame our understanding of current market conditions and what events we might be able to anticipate.
Please keep your family and friends healthy during this pandemic. We are eagerly anticipating a return to the office and the opportunity to meet with you in person with safety measures in place.