Understanding Equities: Economic Cycles and Equity Performance

In investing, there is nothing that always works, since the environment is always changing, and investors’ efforts to respond to the environment cause it to change further.” – Howard Marks, Mastering the Market Cycle

Introduction

Like most all things, the economy is subject to both cyclical (short term) and secular (long term) trends. Here we will delve deeply into economic cycles, which are characterized by periods of expansion and contraction in economic activity and play a critical role in shaping the outlook for equities of different stripes and sizes. Measuring, mapping, and forecasting the global economy (although a challenging pursuit) can offer asset allocators insight into investor sentiment, the projected path of corporate earnings growth, and interest rate policy (as enacted by officials at the Federal Reserve). Additionally, a refined and forward-looking macroeconomic modeling process allows the team at Red Oak Financial Group to study analogous periods from the past and mine history for useful bits of market wisdom that can inform cycle positioning in the present. Below, we will explore how economic cycle dynamics may impact equity prices.

Understanding Economic Cycles

Economic cycles can be broadly categorized into four phases: expansion, peak, contraction/recession, and trough.

Expansion: During an expansionary phase, economic indicators such as gross domestic product (GDP) growth, business payroll headcounts, loan originations, and consumer spending tend to advance at above average rates. A combination of increased business to business transactions and rising consumption on the part of the household sector has historically led to expanding corporate profits. Resultingly, equity prices generally increase as investor sentiment improves and capital is gradually reallocated to stock market investments.

Peak: This is the transition phase where the economy reaches its maximum output for the current economic cycle. The rate of change of growth begins to slow as the economy nears full employment and a majority of the prime opportunities for business growth have already been funded. While some equity sectors may continue to perform well, market-wide volatility (the magnitude of the change in intraday security prices) tends to inflect higher as investors reassess their prior estimates for corporate profitability and the economy moreover.

Contraction/Recession: All good things must come to an end (temporarily at least). The Bureau of Economic Research (NBER) loosely defines a recession as a “significant, widespread, and prolonged decline in economic activity that last more than a few months.” Colloquially, although not officially, most market practitioners think of a recession as two or more consecutive quarters of negative GDP growth. A contraction is merely an economic downturn that does not meet the criteria for a recession. Characterized by declining economic activity, recessions and contractions have been temporally coincident with lower corporate earnings, rising unemployment, decreased consumer spending, and a reduced level of bank lending. Equity prices generally decline during this phase of the economic cycle as investor sentiment becomes pervasively bearish and stock owners divest from equity positions to support current financial needs. Less economically sensitive sectors of the market (utilities, consumer staples, health care) have generally outperformed segments like industrials, energy, and materials whose profitability is more tightly correlated with the economic cycle. It should be noted that, despite the real financial hardships that a deep and protracted economic downturn can cause, recessions are naturally occurring events in capitalist systems. Furthermore, periods of negative growth tend to undo the excesses that accrued during the expansion phase, allowing for creative destruction to take place and setting the stage for future economic development.

Trough: In this phase, economic activity reaches its lowest point. While equity prices may remain low and/or downwardly trending initially, signals of economic improvement (“green shoots”) can precipitate changes in investor sentiment and price performance. Stock prices, in aggregate, have tended to bottom in advance of the economy. As we have written about previously, equity markets are forward discounting mechanisms. In past cycles, it has not been uncommon for small capitalization stocks, value equities, and procyclical shares to lead the market at or around the time that the economy reaches its nadir.

Economic Indicators and Their Influence on Equity Prices

Red Oak, in partnership with our economic data provider Hedgeye Risk Management, tracks the level and rate of change of ~30 high frequency data points to determine the probabilistic path for the domestic and global economy over the medium term (3-6 months). Such a process can be accretive to investment returns and risk management because when taken as a group, the series of data points serve as an economic barometer. Tracking trends in this group of indicators helps asset allocators ascertain where we are in the economic cycle and allows for informed decision making. Below are a few of the data points we analyze most closely.

Gross Domestic Product (GDP): GDP is the most comprehensive measure of economic activity. Rising GDP generally correlates with increasing equity prices as companies experience higher sales and profits. Conversely, contracting GDP can signal an outsized probability that equity prices might experience negative returns, particularly in cyclical sectors like consumer discretionary and industrials. Most market practitioners agree that the rate of change in GDP and other metrics is more influential when forecasting stock market performance than the level of those metrics. Said differently, we are acutely focused on whether the trend in a specific variable is getting better or worse, not whether it is objectively at a good or bad level.

Inflation: Inflation is a natural byproduct of companies increasing the price that consumers pay for goods and services, and therefore moderately positive and stable inflation can be beneficial for corporate profits and share prices. However, to gauge the potential for corporate margin expansion/contraction, input costs as well as output prices must be measured. For that reason, tracking the Producer Price Index (PPI, a proxy for the change in corporate input costs) as well as the Consumer Price Index (CPI, a proxy for the change in the prices corporations charge consumers) is necessary. Additionally, the level and rate of change in the aggregate consumer price level can influence the direction of travel of the risk-free interest rate, which is set by the Federal Open Market Committee within the Federal Reserve.

Interest Rates: Central banks adjust the risk-free interest rate in an effort to influence economic activity. Lower interest rates reduce borrowing costs, encourage investment and consumer spending, and are most often positive for corporate profitability. Conversely, rising interest rates can lead to higher borrowing costs and reduced corporate profitability. Furthermore, the level and projected path of interest rates skew the opportunity cost of owning stocks versus bonds, and therefore impact the buy and sell decisions of institutional and individual investors.

Labor Market Data: Most Americans are reliant on wages, earned through work, to support their consumption and investing. In recent years, ~70% of US GDP has been attributable to consumer spending, making it the most influential category when forecasting the broader economy. Although the monthly Nonfarm Payrolls report (NFP, which is used to estimate the change in month-over-month employment in the domestic economy, excluding agricultural labor) is commonly viewed as the labor market indicator of paramount importance, the data series has a track record of lagging the overall economy. This means that unemployment typically bottoms after economic growth has peaked, and vice versa. For this reason, and others related to the calculation methodology employed by the Bureau of Labor Statistics when computing the monthly NFP figure, it is best practice to assess a wider array of job market statistics to gain a broader perspective. The Initial Jobless Claims data series (detailing how many people applied for first time state unemployment benefits in the prior week) and Continuing Claims (showing the number of people that have received unemployment insurance for 2 or more weeks) provide the necessary context that when combined with trends in the NFP report can be used to round out a model of labor market conditions.

Cycles Within Cycles

Although to this point we have primarily been focused on describing how the cyclical nature of GDP and inflation influence equity market valuations, I would be remiss to not acknowledge that the economy and asset markets are much too difficult to forecast with any degree of accuracy without a full understanding of the cycles that are occurring within the context of the larger GDP and inflation trends. Underneath the surface of our economy, and most every market economy, there are mini cycles that impact the headline GDP and CPI figures.

Credit Cycle: The credit cycle, which is in my opinion the most influential of the mini cycles (most of the time), is the expansion and contraction of credit (primarily bank lending and corporate debt issuance) over time. Given the debt-fueled nature of domestic economic growth, it is important to measure and forecast the amount of lending that is taking place within the economy. A contraction in available credit may foreshadow an impending economic downturn, while expanding loan formation is likely to be stimulative over the short term. Digging down, gaining insight into the factors impacting credit conditions can provide further context. For instance, if bank lending is on the decline, is it because banks are unwilling to lend (a “credit crunch”) or because there is reduced demand for loans on the part of the private sector (a “balance sheet recession”)?

Other mini cycles that the Red Oak Investment Committee monitors are the Inventory Cycle, Liquidity Cycle, and the Commodity Cycle. The interplay between these forces can influence economic stability and asset market performance.

Timing the Market: Challenges and Considerations

While forecasting economic cycles can aid in making informed investment decisions, one must remember that the stock market is not the economy. The lag between economic indicators and reactions in market pricing can present a challenge for investors seeking to allocate towards an economic outcome. For instance, while signs of an impending recession may be visible, equity markets often continue to rally before ultimately downwardly adjusting to the economic reality. For this reason, we continue to reiterate our belief in broad diversification and limiting risk via managing the position size of any tactical trade based on changes in the price, volume, and volatility of the security in question.

Lastly, external factors such as geopolitical events, technological advancements, and changes in consumer behavior can disrupt otherwise staid cycle patterns. Therefore, while forecasting economic vicissitudes is of vital importance to tactical asset allocators, investors must also consider numerous other aspects that weigh on market dynamics.

Conclusion

Economic trends can profoundly impact the everyday lives of US citizens and investors, as well as corporate profitability, sector performance, and equity prices. By measuring, mapping, and forecasting economic cycles the team at Red Oak Financial Group seeks to make informed decisions when managing volatility and risk-adjusted returns across time. While tactical asset allocation presents opportunity for astute investors, a disciplined approach that incorporates diversification, position sizing parameters, and a deep knowledge of historical analogs are table stakes and should not be overlooked. At Red Oak, we strive for continual improvement by refining our investment process as the economy evolves.

Aaron

Aaron Tyburski, WMCP

At Red Oak Financial, we believe in low-cost, low-turnover, diversified, goals-based investing, and take a team approach to asset allocation. As head of our Investment Committee, I regularly present updates on current and forecasted economic trends and a range of probability weighted asset market implications. Chris and Bob have been intentional about cultivating a group of process-focused free-thinking advisors that each bring a unique perspective to the Investment Committee. Although varied our approach, we all strive to act in a way that emphasizes the importance of client outcomes while respecting the uncertainty that is inherent in markets.

Analyzing trends in economic data, risk managing investment portfolios, and disseminating timely market, economic, and behavioral finance-based commentary to our clients and team are my top priorities. In doing so I work closely with our Certified Financial Planners to build low-cost diversified asset allocations that are tailored to the needs and desires of our clients.

I grew up in Upstate New York, the middle of three brothers. Despite my father’s best efforts to turn me into an engineer, I preferred stock charts to heat transfer diagrams. I graduated in 2015 from the University of Albany, SUNY with a Bachelor’s in Business Administration, with focuses in Finance and Business Management, and a minor in Psychology. Post-graduation, I worked as a Financial Analyst at a large manufacturer, and then at a premier financial institution in New York. I moved to Baltimore in search of a new opportunity for growth and am enjoying the intellectual challenge of asset management more than ever.

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