Blog: You, us, everyone

Equity markets are driven by economic events. These events can be secular (i.e. long-term societal trends), but can also be short term in nature. While in the past, economic cycles usually lasted several years (the average was around 9 years), today they are much shorter, i.e. just around 2 years, and the swings between the top and bottom of a cycle are much stronger. 

This has a number of important implications. For instance investors’ investment decisions tend to lag behind the market reality, investment professionals tend to overestimate the upside potential, and sector shifts occur more frequently than in the past. In principle, an economic cycle goes through four distinct phases; expansion, slowdown, contraction, and then recovery. Company performances reflect this to a great extent, but not always at the same speed, as many companies are not just pure plays but tend to be well-diversified. Once an economic cycle has finished, a new one starts; one could argue that there is endless repetition.  

In this context it is opportune to apply similarity and dispersion analysis which can detect opportunities occurring in different business sectors. Based on such analyses, we conclude that the popular conclusion of analysts, fund managers, and TV reporters, saying the US market is overdue for a correction, is wrong. It is true that the US market is in the seventh year of a constant bull run and that the shale oil development and subsequent re-industrialization, which has been driving the market over the past five years, is currently taking a breather.  Yet, there are other sectors, such as the technology sector which is developing and rolling out IOT applications, which are capable of driving the market. Additionally, we know that energy and consumer stocks tend to be more resilient during a contraction phase - which is the next phase for the US market.  

There is always some statistical evidence available that backs one or the other idea; however, no investment decision should be based on statistics only. In times when economic cycles are shorter than ever and the growth resulting from the activity is no longer a linear result but rather an erratic event, it is most important to stick to a disciplined approach. Performance chasing strategies are highly difficult to implement and are more often condemned to fail than succeed over longer periods of time. 

The unique monetary environment created by the principal central banks (The Fed, ECB, BoE, and Bank of Japan) has pushed interest rates to the lowest levels in recent history. In fact, ever since the late 70s, interest rates have, with a few short exceptions, been trending constantly down. This is affecting all three of the principal asset allocations: cash, bonds and equities. While the former two offer no return at all today, the last one has become ultra-sensitive to a few key company figures such as expected earnings growth for the year or two ahead. A company’s lifetime should be viewed as an assemblage of a series of discrete phases, each one quite distinct from the other one. Yet identifying the turning points is key and this is the investment manager’s job. And if we fail, we might prefer to hold on to the stock until the next cycle kicks in, unless there is a predominant and broader negative trend across the sector.

Investors required holding individual stocks (by regulation or by pure peace of mind) are well advised to consider the new paradigm and adjust their view accordingly. Capital preservation and income generating models are condemned to produce significant negative returns in the coming quarters, while strategic allocation exploiting the particular opportunities of strong secular growth trends will require the investor to work to at least a 5 year time-frame.