Follow the Cycle. Richard Bernstein

Transcription

1 Follow the Cycle Richard Bernstein 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 This Time is Different. 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 different 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 government 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 high multiplier 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 recession 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 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 and Consumer Discretionary stocks were among the top performers, and handily outperformed the overall during the time period.

2 Chart 1: (3/31/09 3/31/10) 21% 36% 35% 30% 58% 56% 50% 73% 70% 0% 20% 40% 60% 80% Source:, Bloomberg 83% The mid-cycle 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 03/31/10), Technology and moved up in the sector performance rankings, and significantly fell. Chart 2: (9/30/09 3/31/10) 3% 3% 7% 6% 13% 13% 11% 10% 0% 10% 20% Source:, Standard & Poor's, Bloomberg 20% 19% 2

3 The late-cycle 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 and 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 consumers credit-related purchasing power. The performance ranks of earlycycle sectors (Consumer Discretionary and ) continued to fall, as did those of mid-cycle sectors (Technology and ). Chart 3: (3/31/10 3/31/11) 5% 4% 16% 11% 24% 22% 21% 30% 40% 0% 10% 20% 30% 40% 50% Source:, Standard & Poor's, Bloomberg The slowdown/recession 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 strategies performance improves as the economy gets incrementally weaker. Within the stock market, sectors such as Consumer Staples,,, and Telecom dominate performance when the economy slows. These sectors 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. 3

4 Once again, this cycle has fit the historical norm quite well. Chart 4 shows sector performance since the stock market s peak roughly at the end of April Just as history would have suggested,, Staples,, and Telecom led the derby. even posted a positive absolute return despite the overall stock market s decline. Chart 4: (4/30/11 9/30/11) -24% -25% -27% -27% -8% -9% - -13% -16% -4% -35% -25% -15% -5% 5% Source:, Standard & Poor's, Bloomberg 4% What s next? 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 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 we buy early, but we ll be there at the bottom 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. is chief executive officer of. 4

5 INDEX DESCRIPTIONS: The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indices. Anyone interested in such further details is free to consult each such sponsor s or originator s website. The past performance of an index is not a guarantee of future results. Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index would require an investor to incur transaction costs, which would lower the performance results. Indices are not actively managed and investors cannot invest directly in the indices. : Standard & Poor s (S&P) 500 Index. The Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad US economy through changes in the aggregate market value of 500 stocks representing all major industries. Sectors/Industries: All sector/industry references in this report are in accordance with the Global Industry Classification Standard (GICS ) developed by MSCI Barra and Standard & Poor s. The GICS structure consists of 10 sectors, 24 industry groups, 68 industries and 154 sub-industries. Copyright All rights reserved. Nothing contained herein constitutes tax, legal, insurance or investment advice, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in, any investment product, vehicle, service or instrument. Such an offer or solicitation may only be made by delivery to a prospective investor of formal offering materials, including subscription or account documents or forms, which include detailed discussions of the terms of the respective product, vehicle, service or instrument, including the principal risk factors that might impact such a purchase or investment, and which should be reviewed carefully by any such investor before making the decision to invest. Specifically, and without limiting the generality of the foregoing, before acquiring the shares of any mutual fund, it is your responsibility to read the fund s prospectus. Links to appearances and articles by, whether in the press, on television or otherwise, are provided for informational purposes only and in no way should be considered a recommendation of any particular investment product, vehicle, service or instrument or the rendering of investment advice, which must always be evaluated by a prospective investor in consultation with his or her own financial adviser and in light of his or her own circumstances, including the investor's investment horizon, appetite for risk, and ability to withstand a potential loss of some or all of an investment's value. Investing is an inherently risky activity, and investors must always be prepared to potentially lose some or all of an investment's value. Past performance is, of course, no guarantee of future results. 5