Follow the Cycle – Richard Bernstein Advisors – October 31, 2011
It remains a mystery to us as to why investors believe each cycle is terribly different from other cycles. The title of a very popular book right now is Ă˘â‚¬Ĺ“This Time is Different.Ă˘â‚¬Âť Some cycles are, of course, stronger and some are weaker, and some cycles last longer than others. However, the investment implications at different points in the cycle remain remarkably consistent. With the exception of bubbles, we have yet to come across a truly Ă˘â‚¬Ĺ“differentĂ˘â‚¬Âť investment cycle. Most important, the typical cyclical rotations within the global financial markets are following their normal pattern even during the current cycle.
Sector performance during the past three years has closely followed the historical patterns of sector performance. Admittedly, we have chosen the dates to prove our point because there is never a formal announcement that the economy has changed phases of the cycle.
The early cycle
Despite recent political rhetoric, the early portion of an economic cycle is usually dominated by the governmentĂ˘â‚¬â„˘s monetary and fiscal policies. The Fed lowers interest rates in an attempt to stimulate traditional credit-sensitive sectors of the economy like housing, autos, and retailing. These industries have historically been called Ă˘â‚¬Ĺ“high multiplierĂ˘â‚¬Âť industries, which means that positive developments within the sector tend to stimulate other portions of the economy. (For example, if one buys a house, one tends to buy furniture and appliances, too.) At the same time, fiscal spending tends to dampen a recessionĂ˘â‚¬â„˘s negative impact on household cash flow through both transfer payments (i.e., unemployment insurance) and public-sector employment.
Historically, stock performance during early cycles is dominated by Financials and Consumer Discretionary, which are the most credit-sensitive sectors. In addition, lower quality and smaller companies tend to outperform because they are typically more sensitive to changes in the economy.
The following chart shows that early-cycle industries did indeed dominate performance at the beginning of this cycle. During the first year of the current stock market cycle (from March 2009 through March 2010), the best performing industries were predominantly early-cycle. Chart 1 shows that both Financials and Consumer Discretionary stocks were among the top performers, and handily outperformed the overall S&P 500 during the time period.
A hand-off of economic stimulus from the government to the private sector tends to be the transition from the early to the middle portion of an economic cycle. Corporate investment tends to dominate the middle portion of a typical economic cycle as consumption continues to expand and begins to outstrip existing capacity.
Chart 2 shows that the current cycle as it progressed once again mimicked the historical precedent. Although Consumer Discretionary stocks remained the top performer for this period (9/30/09 Ă˘â‚¬â€ś 03/31/10), Technology and Industrials moved up in the sector performance rankings, and Financials significantly fell.
Late-cycle environments are usually characterized by production bottlenecks and inflationary pressures (Remember that inflation is a lagging indicator of the economy.). Commodity-related sectors tend to perform well during this period because these sectors tend to have significant pricing power relative to other parts of the economy. From March of 2010 to March of 2011, the best performing sector was Energy and Materials ranked third (see Chart 3).
Early-cycle sectors, which tend to focus on the consumer, tend to perform poorly during this portion of the cycle because inflation puts upward pressure on interest rates which constrains consumersĂ˘â‚¬â„˘ credit-related purchasing power. The performance ranks of earlycycle sectors (Consumer Discretionary and Financials) continued to fall, as did those of mid-cycle sectors (Technology and Industrials).
Investors seem to spend too much time trying to ascertain the probability of a recession occurring. Although it makes for good conversation, the investment strategy for an economic slowdown is pretty much the same as is one for a full-blown recession.
Defensive strategies tend to work during both a slowdown and a recession. It is typically the depth of a slowdown that determines the success of defensive strategies. History shows that defensive strategiesĂ˘â‚¬â„˘ performance improves as the economy gets incrementally weaker.
Within the stock market, sectors such as Consumer Staples, Health Care, Utilities, and Telecom dominate performance when the economy slows. These sectorsĂ˘â‚¬â„˘ sales and earnings tend to be more stable than are those in more cyclical sectors (i.e., no matter what goes on, people still eat). Although the overall stock market declines during these periods, the relative performance of defensive sectors tends to better protect an overall portfolio.
Once again, this cycle has fit the historical norm quite well. Chart 4 shows sector performance since the stock marketĂ˘â‚¬â„˘s peak roughly at the end of April 2011. Just as history would have suggested, Utilities, Staples, Health Care, and Telecom led the derby. Utilities even posted a positive absolute return despite the overall stock marketĂ˘â‚¬â„˘s decline.
We have been defensively positioned in our funds for some time now. However, one must be careful not to get mired in the negative news flow, and we are carefully monitoring our leading indicators for improving fundamentals.
History suggests that early-cycle sectors, again sectors like Financials and Consumer Discretionary, might be the likely candidates to outperform in a renewed cycle. An increasing number of observers are beginning to highlight the value in these sectors, yet few seemed concerned about buying early. Value investors err by buying undervalued stocks too early. The often used phrase Ă˘â‚¬Ĺ“we buy early, but weĂ˘â‚¬â„˘ll be there at the bottomĂ˘â‚¬Âť is commonly the route to buying value traps and underperforming.
We will continue to follow our broad array of leading indicators to try to identify when the cycle is turning, and when it will be appropriate to again return to early-cycle stocks.
(c) Richard Bernstein Advisors