October 2018
Making the Most of Market Cycles
By Tim Courtney, Chief Investment Officer
Market participants are often trying to gauge where the economy is in the market cycle. Are we in the growth phase? Nearing the peak? Slowing toward a recession?
As is often the case though, making accurate predictions about future events is difficult to say the least. Many investors are harboring a creeping sense of doom, reasoning that the record bull market must come to an end. Rather than slowing, many economic indicators such as gross domestic product (GDP) growth, recently recorded at 4.2 percent1, are confirming growth as opposed to a slowdown or contraction.
Nonetheless, many try frantically to guess the next several months of market behavior.
One strategy investors oftentimes want to employ is market timing. This sounds appealing on the surface – avoiding downturns and then re-entering markets after the news gives us the “all clear” signal. But for this strategy to work, your predictions have to be pretty spot on. Take a look at a few scenarios we studied here at Exencial surrounding the last two market corrections we have experienced.
If you bought into the equity market beginning March 2016, just following the correction that ended in February2, and then sold at the end of January 2018, just before the start of the next correction2, your return would have been about 58 percent3. This compares pretty favorably to an investor who had the misfortune of investing right when the first correction began (December 2015) through right when the second correction ended (March 2018) as that return was only 35 percent3.
However, let’s say that you just missed perfect timing and bought in one month late (April 2016) and sold one month early at the end of December 2017. Your average return would have dropped 20 percent to 38 percent3. This is nearly the same as the investor who stayed invested through both corrections. When you factor in trading costs and potential taxes due from realized gains, the net return would actually be worse. Taking it even further, if you missed perfection by two months on both the front and back-ends, your return would be closer to 34 percent3 on average, worse after costs and potential taxes.
Predicting market cycles is not obvious or easy. From our perspective at Exencial, you have to ask yourself if you can be perfect with timing. If not, then how close to perfect do you have to be for a timing strategy to work? Many times the answer is in terms of weeks, not months or quarters. There is a fairly small margin for error.
However, there are a couple of strategies that can help hedge the repercussions of a pullback or a recession. First, we generally recommend holding some cash and/or bonds at all times. This is either for cost of living needs or to be opportunistic, i.e. when a downturn does occur you can utilize the cash to buy assets that have fallen in price.
Second, we make sure to focus on areas of the market that are priced reasonably. Stocks with lower prices often tend to have higher expected returns4, and vice versa. For example, the technology sector has delivered high returns in recent years5, but it is important that investors are not too overweight in these stocks as the last several trading days have shown.
We believe these strategies are more effective than trying to time markets and business cycles. As Paul Samuelson many years ago quipped, “The stock market has called nine of the last five recessions6.” Taking near-term market movements and using them as guides to make calls on cycles hasn’t gotten any easier since.
Sources:
1 MarketWatch – Second quarter even stronger than it first looked: GDP raised to 4.2% from 4.1%
2 Fox Business – Past corrections: Drops of 10 percent or more in the S&P 500
3 Internal study conducted by Exencial
4 Forbes – Low-priced stocks bring higher risk and reward
5 Investopedia – 6 reasons why the tech bull market may end
6 NPR – Paul Samuelson, Seminal Economist, Dead At 94
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