Analyzing Business Cycles: It's All in the Timing

 |  Includes: DIA, QQQ, SPY
by: James Picerno

Tuesday's powerful rise in the stock market offers an easy target for rationalizing that the five-month-old correction in equities is over. Perhaps, but your editor is suspicious.

Yes, there's no getting around the fact that Tuesday's 3.7% jump in the S&P 500 is one of the better daily gains on record. But the human mind is too easily influenced by the most recent events while minimizing older trends. For our money, the older trends are still in force, which is to say that all the obvious threats to a sunny outlook for stock prices still apply: Higher energy prices, continuing fallout from real estate, the accumulating evidence of an economic slowdown or worse, and so on. All of these items, and more, threaten to weigh on the stock market in the weeks and months ahead. One more Fed decision intent on liquefying the otherwise gummed-up credit market doesn't materially change much for this writer's intermediate term outlook.

Yes, the Fed's accumulating actions will eventually be a contributing factor that turns the strategic sentiment to positive. But the idea that this moment arrived on Tuesday afternoon looks slightly premature.

That's only a guess, of course, and so the new bull market may be underway as we write. The S&P 500 was off roughly 15% as of Tuesday's intraday low from the all-time high set last October. That's hardly trivial. But considering the context of the last several months, one can reason that the selling is driven by the fundamental deterioration in general economic conditions. If so, the central question is whether those deteriorating conditions have ended or are about to end in the near future? On both counts, our forecast is "no."

Again, we have no way of knowing for sure and so one shouldn't fully discount the possibility that the stock market's headed for higher ground. In fact, there's an inherent danger in assuming that economic cycles and stock market cycles align in real time. In fact, they very definitely do not. That's an important caveat to keep in mind in the months ahead. The risk of being early or late is forever present in timing the bottom, which convinces us to diversify strategic and tactical bets over time as a tool for grabbing the opportunities that corrections inevitably offer while keeping risk at bay.

If the past is any guide, the stock market will be looking for signs that the economic pain is over. The market, as a result, may repeat its former glories by anticipating the recovery well ahead of the statistical evidence that the recovery is written in stone. In other words, waiting for clear and compelling evidence that economic growth is accelerating risks missing a sharp rise in the stock market that anticipates the rebound.

Or not. Sometimes the market divines the rebound in advance, sometimes not. Much depends on the context. Timing is important, of course, but no one should assume there's an iron law that makes investing in real time obvious based on drawing lessons from the past. That's unsurprising since every business cycle begins, unfolds and ends for a variety of reasons that have limited, if any, relationship over time.

Consider the past two recessions, as defined by the National Bureau of Economic Research [NBER]. The 1990-1991 recession and the 2000-2001 recession were identical in length--eight months. But the timing ideal was different in each for winning the investment race.

For each downturn, we looked at four different timing decisions using the Russell 3000 as a proxy for the U.S. stock market and the monthly start and end dates for the recessions, as per NBER:

  • The EARLY strategy: buying the Russell 3000 three months before the onset of recession.

  • The START strategy: buying the Russell 3000 at the end of the month for which the recession starts.

  • The DURING strategy: buying the Russell 3000 three months after the onset of recession.

  • The AFTER strategy: buying the Russell 3000 at the end of the month in which the recession ended.

  • In all four cases, we computed returns as of 12 months after the official end of the recession. These are the results:

  • In the 1990-91 recession, the DURING strategy was the clear winner, delivering a 45% cumulative gain. The worst-performer was the AFTER strategy, posting a cumulative rise of 13%.
  • The tables turned in the 2000-01 recession, which witnessed the AFTER strategy in first place, albeit a meager one with only a 4% cumulative rise. Meanwhile, the EARLY strategy was a loser in absolute and relative terms, imposing a cumulative loss of 26%.
  • In fact, our research shows that as we analyze business cycles further back in history, the random results among the four strategies listed above remain intact. The lesson is that every business cycle is different as are rules for timing the cycles with an eye on maximizing the potential for gain. No surprise, really, as this is just one more way of reminding that the future's always unclear.

    That leads us back to our belief in gradualism in adjusting a multi-asset class portfolio to take advantage of prevailing conditions. As asset classes become more, or less, attractive over time, strategic-minded investors should make tactical shifts accordingly. But just as we're loathe to bet the house on any one asset class, we're equally suspicious of making just one tactical adjustment in asset class weights at any one point in the cycle. The reasoning boils down to our view that - we're all risk managers now.