FYI | May 18 2009
(This story was originally published on Wednesday, 13 May 2009. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere.)
Asset strategists at Credit Suisse in Europe have tried to capture the four seasons of financial markets into one Business Cycle Clock. I think this commendable effort is nothing less than required reading for anyone with even the slightest ambition to participate in buying, selling and owning financial assets. We can all get carried away with the trend du jour, or with the latest data release, but at the end of the day those investors who manage to read the broader picture well, achieve better returns than others over a longer time frame. There’s simply no discussing this fact.
Credit Suisse’s Business Cycle Clock can serve as a handy tool at all times, and under all circumstances. I know, I have said this before, but to those who read this week’s editorial: I think you should print this one out and keep it in your most treasured folder. Re-read whenever your memory gets cloudy, or needs refreshing, or whenever you feel another look is required.
Readers who do not see the Clock included in this story, or for whom the text on the illustration might be too small, can download an acrobat version (pdf) of it HERE (from the FNArena website) or HERE (from the Credit Suisse website).
Let’s start with the theory first.
The Business Cycle Clock divides the economic cycle into four stylized phases: “Recovery” (also known as the economic spring) when output is growing but is either below or close to trend; “Overheating” (summer) when output is growing and above trend; “Slowdown” (fall) when output is above trend but falling; and finally “Contraction” (winter) when global output is both below trend (possibly negative) and falling.
As I write this editorial, on May 13, 2009 the world economy is still in the “Contraction” phase, but investors are hoping we might soon move into spring (“Recovery” phase).
The importance of this switch cannot be underestimated. It should signal the end of outperformance by corporate and government bonds over equities, and also the end of outperformance of defensive sectors in the share market over cyclical sectors with a higher beta. This process has already become apparent in global share markets.
In the Recovery phase, equities and commodities perform best among all asset classes. Long-term government bonds perform relatively poorly.
As the global economy moves through the Recovery phase, the performance of equities tends to mirror that of the broad asset classes, reports Credit Suisse, with the commodity-based energy and materials sectors performing well. This is usually also the case for financial stocks, benefiting from low interest rates, as well as for the cyclicals among industrials.
Similar to the sovereign bond market, traditionally defensive sectors such as utilities and health care tend to be the weakest performers. At the corporate level, earnings and earnings momentum rise from low levels, and share market multiples are again expanding in anticipation of stronger earnings growth.
Next thing we know, the global economy starts Overheating (summer). The summer period is not only the strongest of the four phases in the economic cycle, it also marks the beginning of the end of the good times (for those who dare to look forward with anything else than rose coloured glasses).
As the economy progresses throughout the Overheating phase, the best-performing sectors tend to be late cyclical ones such as information technology, utilities and energy. The worst performers in this phase are typically the telecommunication services and consumer discretionary sectors.
In general, however, investors should start anticipating the end of the good times and both equities and commodities should underperform long-term government bonds. In addition, reports Credit Suisse, cash is a better alternative to commodities.
The next phase is the Slowdown (fall). This is when economic activity is most likely responding to policy actions and/or imbalances in economic and financial market conditions. This is also when inflation tends to be high and indicators about consumer spending and manufacturing and services output start reflecting times are getting tougher. This is also when corporates tend to have high leverage and thus deleveraging becomes the new trend.
As we move through this phase, sovereign bonds outperform all other asset classes, followed by cash. Performances for equities and commodities are usually negative in this phase.
On the share market, defensive stocks outperform others. These include consumer staples, utilities and health care.
The next phase is the worst in the cycle: Contraction (winter). History shows long-term government bonds are the place to be when the economic winter kicks in. As the global economy is weak, maybe even negative, commodities are the weakest performer. This is a time of government stimulus and falling interest rates (both in support of the economy) and while cash might still outperform equities, its returns are nevertheless poor because interest rates are falling.
Looking at share market sectors, cyclicals tend to perform well, reports Credit Suisse, mostly because investors start anticipating the end of the economic contraction. Some defensive sectors like consumer staples also tend to do well. Financials and energy are usually the weakest performers during economic winter.
Some explanation about the eight styles for equities investing mentioned on the Business Cycle Clock:
1. Value. Investors adopting a value style of investing are in particular looking for stocks which share low valuation and sound fundamentals (high quality). Value investors must have an eye for long-term opportunities, since value can take time to materialise. One of the world’s best known value-type investors is Warren Buffett.
2. Growth. A growth style of investing means focusing on companies that can grow sales, assets and earnings at above-market returns. (The latter is often forgotten about). One of the better known growth style investors is Peter Lynch.
3. Contrarian. Contrarian investors like taking positions in undervalued quality stocks that show poor price performance. It’s all about going against the crowd in the expectation of high returns. One such contrarian investor is Fidelity’s Anthony Bolton.
4. Momentum. Momentum investors are probably best described as “traders” as they seek to take advantage of market volatility by taking short- to medium-term positions while riding market momentum. People like US based market trader Dennis Gartman fit in this category, as well as Chicago money manager Richard Driehaus. Both will tell you making money is all about buying high and selling even higher (as opposed to “buy low and sell high”).
5. Size. A size-based investment style is all about market capitalisation. Historically, small cap stocks tend to outperform large caps in bull markets and when investor appetite for risk is high, but large caps are safer during economic downturns.
6. Cyclical. Cyclical stocks are highly correlated with underlying economic conditions. Cyclical industrial companies, like carmakers and white goods firms, tend to be in demand when overall economic confidence is high.
7. Defensive. Defensive companies are characterised by a low correlation to economic growth. In other words: these companies should be able to grow earnings regardless of whether the overall economy is expanding or not. Defensive investors place a large proportion of their investable assets in bonds, cash equivalents, and stocks that are perceived as defensive.
8 Income generator. An income generator style is in essence a defensive style of investing. Investors adopting this style seek out well-established companies that will return cash to shareholders given steady cash generation and limited investment opportunities (the latter means these companies are happy to continue paying dividends to their loyal shareholders instead of trying to find the next corporate target to buy instead).
Time to expose some contrarian anomalies. As shown on the Business Cycle Clock, at times when economic growth is slowing, adopting a Growth style of investing tends to generate the highest returns. Credit Suisse explains this through the fact that deteriorating circumstances forces investors to zoom in on stocks with either historically or structurally high earnings growth rates. One example is health care stocks, which on another measure are also categorised as defensive.
Once economic weakness is giving away for growth recovery, however, value stocks -quality companies at low multiples- are the best options on offer.
Reports Credit Suisse: “toward the end of a Contraction phase and into Recovery, a value strategy tends to beat a growth strategy… in a Slowdown phase, growth on average has negative returns. Contrarian, income generating and defensive styles tend to generate above-average returns during economic slowdown and contraction periods. Similar to cyclicals, momentum strategies work best in the Recovery and, in particular, the Overheating phases of the business cycle.”
As with equities, reports Credit Suisse, one can divide the bond universe into styles according to two key attributes; maturity (or duration) and credit quality. Duration reflects the sensitivity of a given bond to changes in official interest rates. The longer the duration, the greater the effect a change in interest rates will have on the value of the bond. Credit quality is all about the perceived chances that the government, municipality or company issuing the debt might not be able to repay the debt (in time) as promised.
According to Credit Suisse’s analysis, investors tend not to be rewarded by going longer duration during the Recovery and Overheating phases, while long maturity bonds perform best during the Slowdown and Contraction phase.
Equally, high-quality bonds usually outperform when the global cycle indicator is above trend (Overheating and Slowdown phases) but underperform during the Recovery and Contraction phases when economic output is at or below trend.
And now for the key question: where are we now?
As we all can see on the Business Cycle Clock above, Credit Suisse does not believe we are yet in the Recovery phase. Maybe time to point out that while Asian economies appear to be showing signals of economic recovery, most of the nearly 40 economies that form the basis for this Clock are still contracting, albeit at a slowing pace.
Investors, however, have already started to anticipate the next phase in the cycle as witnessed by recent outperformances for value stocks, cyclicals and smaller caps over defensive stocks such as telecom companies and health care providers. Blue Chip stocks have underperformed small caps since the beginning of the year. Financial stocks have outperformed everything else since early March.
Can we conclude from this that the economic recovery lies around the corner? Absolutely not. Or as Credit Suisse puts it:
“equities and credits usually begin to recover towards the end of a Contraction phase, as markets anticipate a recovery and, while we have seen some stabilization in the performance of economically sensitive or cyclical sectors relative to defensive ones, the recent falls in equities suggest it may be too early to herald the end of this Contraction period”.
With these thoughts I leave you all this week,
Till next week!
Your editor,
Rudi Filapek-Vandyck
(as always firmly supported by Greg, Andrew, Grahame, George, Pat, Chris and Joyce)
P.S. Credit Suisse’s Business Cycle Clock is based upon four parts in the standard economic cycle during which GDP growth is either above or below potential and either rising or falling. In addition, historical analysis shows financial markets tend to run ahead of the economic cycle by roughly three to six months, says Credit Suisse.
P.S. 2 Credit Suisse’s approach/analysis has not taken into account that during the strongest phase of the economic cycle, aptly called Overheating, investors can get carried away too much by the sunny weather and simply shoot for the moon and forget all about what might come next. While share markets might try to anticipate a better economic and financial environment well before this has become a sinecure, we have all witnessed since late 2007 there was no such anticipation of the Slowdown, with share markets surging to new highs as late as November 2007 (when in hindsight the world’s largest economy was already in recession).
P.S. 3 All cycles are different in their own right and this time around an interesting difference is occurring between economies in Asia, which seem on their way to recovering growth (early signals though), but with the major developed economies (US, Europe and Japan) showing at best early signals of a stabilisation in the economic contraction.
P.S. 4 We have produced a Special Report on the basis of this story which also contains a large size display of the Business Cycle Clock. This report in pdf might prove easier to print. Members can download this report from our Special Reports section in the FNArena Cockpit on the website.
