Highlights.

  • Both the economy and the stock market tend to evolve in a cyclical pattern that resembles a sine wave.
  • Trying to adapt a portfolio’s asset allocations to correspond to the current stage of the economic or market cycle is referred to as cyclical investing.
  • Successfully implementing a cycle-driven sector rotation strategy over a long time period is very difficult because each economic and market cycle is unique.

The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.

– Billionaire Investor Seth Klarman

A sine wave is a repetitive change or motion which, when plotted as a graph, has the following pattern.

The concept of the sine wave is a centerpiece of several disciplines, including mathematics, physics, and engineering.  Waves in the ocean, sound, alternating electrical current and the number of minutes of daylight gained or lost in a day can all be illustrated by sine waves.

Both the economy and the stock market are commonly depicted as cycling through four distinct phases in a sine wave pattern.  Economists have identified four phases of the economic cycle as expansion, peak, contraction, and trough.  By comparison, market commentators refer to the four phases of the stock market as bull market, market top, bear market, and market bottom.

As the chart below illustrates, the economic and market cycles have a symbiotic relationship, with the market cycle preceding the economic cycle.  The rationale is that financial experts and investors see the economic cycle signs turning before the economic data confirms the change with lagging numbers.

“Cyclical Investing” refers to an investment strategy whereby the investor seeks to capitalize on the symbiotic relationship between the different phases of the U.S. economy and the stock market by adjusting portfolio allocations to correspond to the current state of the market or economic cycle.

While there is no shortage of cyclical investment strategies, they boil down to one basic premise:  If the economy appears to be on the downswing, invest conservatively.  If, on the other hand, the economy seems to be expanding, invest more aggressively. 

Perhaps the most common way to implement a cyclical investment strategy is to target various sectors of the stock market, based on the presumed state of the economic cycle.  This approach to cyclical investing is known as sector rotation.  It is grounded in the premise that, all other things being equal, during each phase of the economic cycle some business sectors prosper and others struggle.  Not surprisingly, the goal is to overweight the sectors that are expected to outperform and underweight those that have a history of underperforming during the current phase.

Sounds easy, right? Unfortunately, it’s not.

Successfully implementing a cycle-driven sector rotation strategy over a long time period is very difficult for three principal reasons.  First, consistently identifying where the economy or market is at for their respective cycles at any given time, with a high degree of precision, is no easy task.  That’s because a countless number of variables influence both cycles.

Second, neither the stock market nor the economy reflects a perfect sine wave.  Rather, both the stock market and the economy follow irregular patterns that bear only a faint resemblance to a sine wave.  Each pass through the cycle is unique and so there are no widely accepted rules of thumb as to how long a particular phase should last.  As a result, even if the current stage of the cycle is correctly identified, trying to time when one phase ends and the next one begins without the help of a crystal ball is very difficult.

Thirdly, there are numerous influences other than the economic cycle that can impact how market sectors perform.  As a result, the ways various market sectors respond to different phases of the cycle can vary significantly from one cycle to the next.

In short, while there is good reason to believe a cycle-driven sector rotation strategy can produce favorable returns over numerous market cycles, such a strategy can also produce disappointing results over a single economic cycle.  As a result, this investment approach is best suited to disciplined, patient investors who are willing to stick with it even in the face of several years of under-performance.

For the rest of us, a less ambitious version of a cycle investing strategy may be preferable.  Such a strategy involves uniformly overweighting bond allocations by 5%-15% when it appears the economy is entering a recession (i.e. the economy is contracting); overweighting equities by the same amount when it appears the recession has ended (and as a result the economy is expanding rapidly); and adopting a neutral weighting consistent with the investor’s personal risk tolerance the rest of the time (i.e. when the economy grows at a “normal” pace). 

As a generic example, an investor with a moderate-to-long-term investment horizon and who seeks to strike a balance between growth and stability might allocate 65% to bonds when the economy appears to be entering a recession, 65% to stocks following the end of a recession and have a 50/50 allocation to stocks and bonds the rest of the time.

The rationale is two-fold:

  • While timing all phases of the economic cycle or market cycle in real time is nearly impossible, a number of economists agree that the start and end of a recession can be identified as they occur (or with a short lag) with reasonable certainty.
  • Although the way different market sectors respond to the phases of the economic cycle can vary from one cycle to the next, the way that stocks and bonds respond to the economic cycles is more reliable: bonds do better than stocks during recessions, and stocks outperform bonds after a recession ends.

The implementation of the above described cycle investing strategy only requires the investor to identify in real time when a recession has begun and when it has ended.  There are many resources available to assist an investor with this task.  One such resource is The Milwaukee Company’s Economic Briefing Report, which is a round-up of a number of leading economic indicators.  The latest copy of our Economic Briefing Report can be found here.  Another is The Capital Spectator’s U.S. Business Cycle Risk Report, authored by Jim Picerno, who is the Milwaukee Company’s Director of Analytics and Investor Education.

I am also pleased to announce that as of March 5th, The Milwaukee Company will begin posting The Milwaukee Company’s Recession Index (“MCRI”).  I will be writing about MCRI in next week’s blog.

My first introduction to sine waves came from the introduction to the 1960’s Sci-Fi show “The Outer Limits”.  The short-lived ABC TV series became a cult hit in syndication and was revived in 1995 on Showtime.  The original series hosted an impressive roster of guest actors, including Bruce Dern, Cliff Robertson, Carroll O’Connor, William Shatner (as an astronaut on a mission with the prophetic name Project Vulcan), Martin Landau, and Martin Sheen.  But the series is perhaps best remembered for its eerie introduction, which is a true classic.  You can watch it here.

Thank you for reading.

The Market Commentator

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