Market Cycle Highs and Lows: Why They’re Important and How You Can Prepare For and Profit From Them, Part II
Published on October 1, 2020
If you haven’t read the preceding post, please do so here. Otherwise, you will be missing some valuable background information and starting the movie halfway. As mentioned then, we will be covering the following topics in this post:
- Adapting to the Market Cycle
- Cycles in International Markets
- Additional Resources
After this post you should have the basic building blocks for understanding market cycles and how you can adapt to them. For those wanting to go further, the additional resources should keep you busy for a while.
Adapting to the Market Cycle
One can implement this knowledge of cycles in several ways depending on how actively one manages one’s portfolio. Here are a few examples that many investors may be doing already. I have listed them by increasing levels of engagement.
- Adjusting target asset/class and sector allocations
- Traditional value investing
Rebalancing: Rebalancing is a super easy way to play cycles. To rebalance, you need a target allocation between assets in your portfolio, the classic being the 60/40 stock bond portfolio (note: this is an example, not an endorsement). With this target allocation, you will periodically buy or sell stocks and bonds to return to that 60/40 split. This means you will be selling your winners and buying your losers under the belief that your winners are approaching the top of the cycle and your losers are closer to the bottom of the cycle. Vanguard, Betterment and your 401k should allow you to do this.
Adjusting target asset/class and sector allocations: In addition to rebalancing, and to use the allocation example above, you can adjust your target allocations based on where you are in the cycle as well. For example, at the market top, you may want to be 40/60 stocks and bonds given that stocks typically underperform bonds into a bear market and 80/20 at the beginning of a bull market as stocks will outperform bonds.
This strategy is not limited to stock indices or bonds more generally. Cash, Real Estate, and different types of businesses all have different return profiles in the cycle. For example, utilities are similar to bonds and perform best on a relative basis in bear markets and troughs. Steel manufacturers, however, are very dependent on growth in the economy and outperform in the early part of a bull market. At the top of a market you want to own the former and the latter at the bottom.
Fidelity Investments’ Asset Allocation Research Team published an analysis here talking about the different return profiles of stocks, bonds and cash during various stages of the economic cycle. The view is that, depending on the point in the cycle, different asset classes will perform better with bonds performing best in the market top and bear market while equities perform best at the bottom and bull market. The article also attempts to analyze different sector performances in the equity market during the cycle.
For more active investors, Hedgeye does a wonderful job mapping this out based on their own modeling and view of the cycle. Check out their website to learn more. There is no compensation here for the referral, but they are dedicated to their framework and explain it clearly to potential clients. Even if you don’t agree with all of it, there’s certainly something to learn. They map out allocation recommendations based on where they see the economy in the cycle.
Traditional Value Investing: This is a strategy where one does most of their active investing after a recession has started and there’s a bear market. The notion is highly romantic and can be very profitable. The only issue is that you end up making most of your great investments in relatively short windows of time and then are less active during the rest of the cycle. This truly tests one’s patience. As we’ll discuss below, if there are multiple different cycles in different countries, this can be a powerful tool to bottom fish more regularly. This will be a key focus for the blog so there will be more on this later.
Cycles in International Markets: Special Considerations
What we have talked about so far largely relates to a single economy or market. When we have multiple economies and markets, we have the potential to analyze and invest in markets at different stages in their cycles and this can increase returns while decreasing risks. Smaller countries can also have cycles with greater volatility and growth relative to the cycles in larger economies like the US.
In the aftermath of the Global Financial Crisis, the financial media focused heavily on this point and coined the phrase “decoupling” when referring to the ability of emerging markets to grow and provide returns to investors in spite of the troubles in the US — and later Europe. Like any good narrative, there is truth to the statement, but many investors discovered the hard way in 2014-2016 that emerging market countries were more linked to events in developed markets than investors had priced in. Thus, while the US markets recovered quickly in 2016, emerging markets have taken much longer.
This underperformance by emerging markets actually presents an opportunity going forward. Emerging markets may be an area to focus on in the coming years given their lower valuations and the different position of the various economies in their cycles in comparison to the US.
In reviewing these two posts, we can lay out some key considerations for investors:
- Understanding where various markets are in their cycles should inform asset class allocations.
- By investing internationally, one can focus investments on markets that are in the recovery stage of the cycle where the risk reward for stocks is at their greatest potential.
- An additional layer can include focusing on sector rotation in a cycle.
In the article, I referenced a few great resources to learn more about cycles. I’ve summarized
them all here for easier access and have included some additional items to explore further:
In the Posts:
- Dalio’s “How the Economic Machine Works”
- Mastering the Market Cycle by Howard Marks
- Anatomy of The Bear by Russell Napier
- Economic Cycle Research Institute
- IHS Markit PMI’s
- Fidelity Asset Allocation Piece
Additional Items not in
- Privatinvestor TV – Russell Napier: Why Bear Markets Happen And Why One Is Likely Now
- Russell Napier covers his framework for understanding what causes markets to roll from market top to bear market and vice versa. He also covers the role of money supply and credit in predicting turns in the business cycle.
- The Great Wave by David Hackett Fischer
- This book surveys inflation cycles from medieval times up to the 1990s and attempts to understand what has caused these cycles. Such a long term perspective is essential for putting modern times into context.
In upcoming posts, I will share my story on applying technical analysis as well as a piece on an unloved controversial commodity sector.
To your investing adventure,
The Castaway Capitalist
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