- Sector rotation strategies tied to the economic cycle are only as good as their ability to identify the current stage of the business cycle.
- A less ambitious approach to cyclical investing is to over-weight bonds when the U.S. economy enters a recession, and to overweight stocks when the recession ends.
- The Milwaukee Company’s Economic Cycle Strategy uses The Milwaukee Company Economic Index to implement such a cyclical investment strategy.
”Only liars manage to always be out during bad times and in during good times.” – Famed investor and Presidential Advisor Bernard Baruch
In 1846 nitroglycerin, (the powerful explosive featured in numerous western TV shows and movies) was invented by Italian chemist Ascanio Sobrero. At that time, gunpowder was the only explosive that was sufficiently predictable to be safely used in mines. While nitroglycerin was much more powerful than gunpowder, it was also very volatile and very unpredictable. As a result, nitroglycerin could explode unexpectedly at the slightest provocation. In fact, nitroglycerin was so volatile that Mr. Sobrero believed it to be unusable.
In 1860, Swedish industrialist, engineer, and inventor Alfred Nobel started experimenting with nitroglycerin in the hope of making it stable enough for commercial use. It wasn’t until 1866 that Mr. Nobel discovered that mixing nitroglycerine with silica would turn the liquid into a stable, malleable paste that he called dynamite. Dynamite’s stability allowed it to be molded into cylinder-shaped sticks that could be inserted into the drilling holes used for mining. Following his death, Nobel’s estate established the annual prize that bears his name and honors achievements in physical science, chemistry, medical science or physiology, literary work and service towards peace.
In last week’s blog I discussed the potential power of investment strategies that move in and out of different market sectors based on the investor’s understanding of the current stage of the economic cycle. I also pointed out that every economic cycle is unique, and the ways various market sectors respond to different phases of the economy’s ebb and flow can vary significantly from one economic cycle to the next. As a result, cyclical investment strategies that call for large sector bets, based on how different markets have responded to past economic cycles, can produce unexpected results.
In my earlier blog post I proposed a predictable cyclical investment strategy. The suggested strategy begins with a diversified model portfolio of low-cost index ETFs that allocates between stocks and bonds in a manner that is consistent with the investor’s personal risk tolerance and investment objectives. For discussion purposes, lets consider a simple 3-fund model portfolio for an investor with a balanced investment objective (that is, an investor who places an equal emphasis on risk management and the rate of return). The strategy invests in the model portfolio when it appears the U.S. economy is stable (i.e. when the economy is growing at a “normal” pace).
|Total Stock Market Fund||40%|
|International Stock Market Fund||10%|
|Total Bond Market Fund||50%|
Each month, the current stage of the economic cycle is determined and the portfolio is rebalanced if there is a change in the macro profile. More specifically, the allocation to bond ETFs would be increased (and the corresponding equity allocations decreased) when it appears economic growth is slowing or contracting. For example, the model portfolio might be adjusted as follows during an expansion:
|Total Stock Market Fund||28%|
|International Stock Market Fund||7%|
|Total Bond Market Fund||65%|
Alternatively, the strategy would over-weight the portfolio’s equity allocations when it appears the U.S. economy is expanding, perhaps as follows:
|Total Stock Market Fund||52%|
|International Stock Market Fund||13%|
|Total Bond Market Fund||35%|
Implementation of the foregoing cyclical investment strategy requires a monthly determination of the current stage of the economic cycle. The good (and bad) news in this regard is that the readily available economic indicators are almost too numerous to count. The fact that there are so many may be the best evidence of how very hard it is to identify with precision the state of the U.S. economy in real time.
One way to cut through the noise, at least in part, is with The Chicago Federal Reserve’s National Activity Index (“CFNAI”), a powerful business cycle index. CFNAI is a weighted average of 85 existing monthly indicators of national economic activity drawn from four broad categories of data: (i) production and income, (ii) employment, unemployment, and hours, (iii) personal consumption, and (iv) housing.
Following a period of economic expansion, an increasing likelihood of a recession has historically been associated with a value of below –0.70 for the 3-month moving average of CFNAI (CFNAI-MA3). Conversely, following a period of economic contraction, a significant likelihood of an economic expansion has historically been associated with a CFNAI-MA3 value above +0.20. Accordingly, the suggested strategy would over-weight bonds when CFNAI-MA3 is below -0.70 and overweight stocks when CFNAI-MA3.
Just as Alfred Nobel added silica to nitroglycerin to make it more dependable, The Milwaukee Company has developed a probit model that we believe that, if used in conjunction with CFNAI-MA3, results in a more dependable indication of when the economy is either stable or slowing. We refer to this more stable combination as The Milwaukee Company’s Economic Indicator (“MCEI”).
I will be discussing MCEI in a future blog post. (If you would like to learn more about MCEI in the interim you can contact me.) For now, the following table compares the start and end dates of the last 2 recessions to the signals that would have been issued by MCEI. (The shaded regions are associated with recessionary periods as determined by The National Bureau of Economic Research.)
The following wealth index compares the performance of the above described model portfolio using a buy-and-hold strategy that is rebalanced annually, with the performance of the same model portfolio using the proposed strategy rebalanced monthly.
The Milwaukee Company’s Economic Cycle Strategy (“ECS”) uses the strategy described in this post (albeit with a somewhat more elaborate model portfolio than the simple 3-fund portfolio outlined above). For you do-it yourselfers, The Milwaukee Company has begun posting the most current weekly reading of The Milwaukee Company’s Economic Index (“MCEI”). You can find the most recent reading here. You can also subscribe to receive notice of future posts at the bottom of this page.
While nitroglycerin was too unpredictable for mass commercial use, it was a blast for one industry town — Hollywood, as this video clip from A Fistful of Dynamite reminds.
Thank you for reading.
The Market Commentator