Macroeconomic data has been mixed over the past year, leaving room for a debate between bulls and bears over the current position within the U.S. economic cycle, and hence the potential for further stock market gains. Last week, we noted the overall falling trend of our Composite ISM PMI index since November 2014 (Investing In Line With The PMIs) despite the uptick since January 2016. Another widely-followed macroeconomic indicator, Industrial Production, is unmistakably heading towards recession territory. The chart below shows the year-to-year change on the Industrial Production index has been contracting since last June:
Real GDP, meanwhile, has been slowing for four consecutive quarters since Q1 2015. The latest estimate has real GDP at +1.9% in Q1 2016. We drew a horizontal line at +0.9%. Since 1948, each time the year-on-year change of U.S. real GDP has fallen below +0.9%, a recession has ensued.
In our investments class, we cover a module on macroeconomic, or top-down, analysis. Among the topics taught, we thoroughly explain to our finance students the leading, coincident, and lagging economic indicators and the business cycle approach to investing. One article that we regularly assign for reading is "The Business Cycle Approach to Equity Sector Investing" written by a team at Fidelity. Novice investors (and even some experienced investors) may find the article useful. We have uploaded the article here. While the article only speaks to investing in the 10 GICS Level 1 sectors, we expand the breadth of our current study to cover all investable sectors (i.e., with a liquid associated ETF), as well as bonds, commodities, and the dollar. We also prefer to break down the economic cycle into five distinct phases:
- Early Expansion
- Late Expansion
- Slowing into Recession
The figure below provides a simplified representation of our phases of the economic cycle.
The theme of this article is not to enter a debate on current macroeconomic conditions or where the U.S. economy is now located in the economic cycle (although we are leaning to the "Slowing into Recession" camp), but rather to highlight the optimal investments in any phase of the economic cycle. We try to link the theory above with the reality in the markets by examining the price behaviour for over 40 asset classes during the economic cycles which have unfolded since 1990. Our division of the economic cycles since 1990 into the five phases was determined by both real GDP levels and length of time for each cycle.
Whether the reader believes the economy is still in "Late Expansion" or "Slowing into Recession", for example, investing in line with the current economic cycle will allow an investor to create a portfolio with the highest probabilistic expected returns.
Actual asset class performance over the five phases did in fact reveal very sharp differences for all sectors depending on their cycle phase, confirming the importance of the economic cycle approach to asset allocation. Our full report presents the tables with sector/asset classes ranked from best to worst based on "Slowing into Recession" and "Late Expansion". The S&P 500 (NYSEARCA:SPY) is shown in bold so that readers can better distinguish the break between market outperformance and market underperformance during each phase.
Considering sector performance since early 2015, sector leadership is currently more consistent with the "Slowing into Recession" phase of the economic cycle. Several examples we noted include:
- The strong performance of biotech up to 2015 (consistent with Late Expansion), then the sector's relative weakness since mid-2015 (consistent with Slowing into Recession).
- The strong performance of the NASDAQ 100 up to late-2015 (consistent with Late Expansion), then the sector's relative weakness in 2016 (consistent with Slowing into Recession).
- The Bank's strong performance up to early 2014 (consistent with Early Expansion), the mediocre performance from 2014 to 2015 (consistent with Late Expansion), and the underperformance from 2016 (consistent with Slowing into Recession).
- The Metals & Mining sector weak performance from 2011 to 2015 (consistent with both Early and Late Expansion), then the sector's outperformance in 2016 (consistent with Slowing into Recession).
Investors will need to be nimble, as the break from "Slowing into Recession" to the "Recession" phase is likely to occur in Q3 or Q4 of 2016. We have observed that the "Slowing into Recession" phase has lasted, on average, three quarters going back to 1948. So if the economy began slowing in 2015, we are certainly more than half way through the "Slowing into Recession" trade. Investors should start becoming prudent on asset classes which typically outperform during the "Slowing into Recession" phase and may want to look ahead to the sectors/asset classes that we found have outperformed in prior "Recession" cycle phases.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.