Bull vs BearDec 01, 2018
It has become something of a mantra that bull markets do not die of old age, but rather by recessions. Although every business cycle is different, historic analysis suggests the rhythm of a cyclical economy has tended to follow similar patterns and played itself out in the equity markets accordingly. Whereby, performance across asset categories typically rotates in line with different phases of the business cycle.Specifically, there are four distinct phases of a typical business cycle:
Cycle phase: marked by an inflection from negative to positive growth in economic activity, then an accelerating growth rate. Credit conditions stop tightening amid easing monetary policy, creating a healthy environment for rapid expansion and profit growth.
Mid-cycle phase: typically, the longest phase of the business cycle. The mid-cycle is characterized by a positive but more moderate rate of growth than that experienced during the early-cycle phase. Economic activity gathers momentum, credit growth becomes strong, and profitability is healthy against an accommodative — though increasingly neutral Central Bank policies.
Late-cycle phase: representative of an “overheated” economy poised to slip into recession and hindered by above-trend rates of inflation. Economic growth rates slow against a backdrop of restrictive monetary policy, tightening credit availability, and deteriorating corporate profit margins.
Recession phase: a contraction in economic activity. Corporate profits decline, and credit is scarce. Monetary policy becomes more accommodative setting up for the next recovery.
Shifts between business cycle phases create differentiation in various asset classes. In general, the performance of economically sensitive assets, such as stocks, tend to be the strongest when growth is rising at an accelerating rate during the early cycle, then moderates through the other phases until returns generally decline during recessions. By contrast, defensive assets such as bonds and cash have experienced the opposite pattern, with their highest returns during a recession and the weakest relative performance during the early cycle.
Investors can implement the business cycle approach to asset allocation by overweighting asset classes that tend to outperform during a given business cycle phase, while underweighting those asset classes that tend to underperform. In the early cycle, for example, the investor, using this approach would overweight stocks and underweight bonds and cash. Stocks have typically benefited more than bonds and cash from the backdrop of low interest rates, the first signs of economic improvement, and the rebound in corporate earnings. Therefore, overweight riskier assets and underweight more defensive asset classes during the early cycle.
Averaging nearly three years, the mid-cycle phase tends to be significantly longer than any other phase of the business cycle. The economy moves beyond its initial stage of recovery and growth rates moderate during the mid-cycle. Stock market performance has tended to be strong. This phase is also when most stock market corrections have taken place.
The late-cycle phase has an average duration of roughly a year and a half. As the recovery matures, inflationary pressures build, interest rates rise, and investors start to shift away from economically sensitive areas. On an absolute basis, average stock performance is roughly in line with cash. Sound familiar? If you look at the TSX market performance year-to-date, its flat. Across the asset classes, the late cycle warrants more of a neutral asset allocation.
Within equity markets, more economically sensitive sectors, such as technology and industrials, tend to do better in the early and mid-cycle phases, while more defensively oriented sectors, such as consumer staples and health care, have historically exhibited better performance during the more sluggish economic growth in the late-cycle and recession phases.
With the equity bull market now well into its tenth year and levels of volatility moving back to more frequent levels, after an unusually long period of calm, it’s probably safe to say we are getting closer to the ninth inning in the late-phase cycle.
Every business cycle is different, to be sure, there is nothing in the current economic data or financial indicators to suggest that a global recession is imminent. However, against this backdrop, barring a big geopolitical event or a full-blown trade war, the global economic expansion appears to have room to run for another year or so, with the risk of a recession rising soon thereafter.
As we enter the last, more volatile phase of a long expansion in this bull market, liquidity, diversification and flexibility will be key to protect portfolios. Thus, it is time for investors to prepare for a potentially long period of more volatility, plateauing asset prices and lower expected returns which often precedes bear markets.
So, what to do? First and foremost, keep your short and longer-term goals in mind and what level of return is required, overall, to get you there. For recessions, market volatility and lower expected returns, when viewed over your time line, are bumps in the road. Be aware of where we are in the cycle and adjust your investments accordingly.
1. Cut your overall risk exposure to those riskier assets within the portfolio, consideration should be given to sector rotation, the movement from one sector to other sectors with the premise that late cycles impact sectors differently and take advantage of how the various sectors respond to the business cycle.
2. Diversify geographically into markets that are in an earlier part of the economic cycle.
3. Step up investments in dividend growth/yield and less in economically sensitive investments.
4. Raise some cash. Sometimes a 10-15% cash allocation at a 1.50% return, on a short-term investment, will have to suffice.
However, using a disciplined approach, as many of you know, our current asset allocation is 35% fixed income, 50% core equity and 15% explore at this time given the general economic environment, which we are comfortable with.
While we don’t know when the current market cycle will end, we do know the final leg of a market cycle can have significant influence on portfolio returns. Many investors are afraid of investing new money, near the end of a cycle, as they fear they will be investing at the peak. But, sitting on the sidelines waiting for a bull market cycle to end can also have negative effects. Remember your goals and timeline and having a strategy in place will help withstand uncertain times.
Sr. Investment Advisor at Savanti Wealth
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