Investors broadly comprehend the theory of market cycles and how asset allocation is critical to mitigating risk through inevitable ups and downs in economic performance. Understanding how to position a portfolio to maximize returns in addition to mitigating risk is critical to success. Below is a general framework to better understand how the Hilton Capital Management investment team incorporates macroeconomic cycles into the decision making process.
There are five distinct micro-cycles that generally define a full market cycle. We’ll break down attributes of each one with the caveat that it’s often very difficult to pinpoint exactly when cycles transition from one to the next.
Perhaps the biggest qualifying statement regarding the movement between cycles is that unforeseen events can clearly intensify not only the peaks and troughs of the individual cycles but can accelerate the movement between them. For example, on the downside, events such as the global pandemic and the global financial crisis in 2008 are interesting examples. Having a keen awareness of economic cycles coupled with a solid macroeconomic research process was of very little help during the pandemic but during the global financial crisis these tools were very useful.
As a counterpoint, sometimes “artificial” economic support in response to these “market crises” such as the recent massive monetary relief in the form of stimulus payments and corporate bond purchases can have an outsized impact on the upside. Or again, using the global financial crisis as an example, the lack of government support can keep an economy languishing for years after the recession ends.
Recovery. The early phases of a recovery period sometimes feel like anything but. In the broadest of terms this is when it’s best to be fully “risk on,” which is typically defined by an overweight to equities that have the ability to generate larger returns during a rebound period. These aren’t the stable so-called Blue Chips that value investors covet, rather they lean toward sales growth and would otherwise feel risky. Portfolio managers will shift slightly toward these “Beta” stocks, which essentially means they have more potential for growth compared to the overall market. This period is marked by earnings expansion and is signified by robust activity in raw materials and heavy construction.
Current Timestamp: It’s likely that as of June 2021 we will be exiting the recovery phase and heading into expansion. Much of this is due to the historically short recession we experienced (in the United States) at the height of COVID-19.
Expansion. Value stocks are beginning to catch up to the beta/sales growth stocks that outperformed the market in the early stages of the recovery. A portfolio will likely remain “Risk On” to a great extent as the economy heats up and equity returns are still favorable to fixed income assets, which will lag slightly as interest rates remain suppressed to spur borrowing, investment and refinancing.
Peak. While the name implies all systems go, it’s actually a slightly more precarious time for portfolio managers who must pay close attention to the shift between phases and begin to look for signs of earnings growth slowdowns. The pace of returns begins to slow but remains largely positive in equities, which makes it difficult to determine the best time to begin to mitigate risk more deliberately. Quality and value take precedence over risk and growth. Earnings per Share (EPS) takes center stage as fundamentals reign during this period.
Growth. This is somewhat of a misnomer. The growth phase indicates the economy as a whole is in later stages of expansion, which makes it increasingly difficult to find consistent earnings growers. EPS growth slows and theoretically interest rates have begun to creep higher as the economic cycle has matured. Therefore, fixed income opportunities become more plentiful while growth equities offer upside potential. Officially, however, portfolio managers will commit to a “Risk Off” attitude and begin to seek safe harbor in concrete long-term performers.
Decline. As the market cycle winds down and heads into a full “Risk Off” scenario for portfolio managers, more defensive positions are worked into the allocation strategy. EPS and Price to Earnings (P/E) ratios begin falling simultaneously making it difficult to find positive returns even from the most stable names in a portfolio. During this phase of the economic cycle, a defensive posture and allocations designed to protect the downside are much more important than chasing yield or growth.
The Best Laid Plans…
The best portfolio managers maintain perspective with respect to market cycles and understand that unusual events—Covid-19, for example—have the ability to toss everything in the air and create confusion in the markets. As mentioned earlier, the financial crisis and global pandemic are both recent enough to prove this concept and put an exclamation point on it.
The right way to incorporate these cycles into financial models is from a macro sense. Utilizing these micro-cycles as a mental benchmark during “normal” times helps create a sense of balance and a reminder that when you clear away unforeseen events and emotion, the market will always try to move toward fundamentals.
Hilton Capital Management staff (“HCM”) and Morey Creative collaborated in the preparation of this article. Morey Creative is a marketing firm engaged by HCM. HCM has reviewed and approved this article for distribution. The information set forth in this article should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the markets involves gains and losses and may not be suitable for all investors. The information set forth in this article should not be considered a solicitation to buy or sell any security.