In the current economic environment, which fluctuates between cautious optimism and pragmatic risk aversion, investors are increasingly recognizing the importance of evaluating investment performance over economic cycles. More so, these investors are having to question the time horizon that they consider a “market cycle”.
When we think of a typical market cycle, the image that comes to mind is the following stages:
Source: ETF Trends | Business Cycle
- Early: A period of recovery from a recession, involving positive economic activity at an accelerating rate of growth.
- Mid: A more modest rate of growth over a longer time period, in which economic activity is still robust.
- Late: This is where “peak” occurs. There is a notably slower growth rate where the economy is “overheating”, creating inflationary pressures and a tight labour market.
- Recession: Contracting economic activity where profits are declining, and credit is hard to come by or is expensive. Eventually, fiscal policy makers institute friendly policies to try to stimulate growth.
Most experts would say that the global economy seems to be trending towards desynchronization. That is, multiple economies are experiencing features indicative of multiple stages (Late Cycle and Early Cycle specifically). Closer to home, the market appears to be in a Late Cycle phase, with policy makers trying to engineer a soft landing for the economy.
From 1945-2020 the typical peak to peak cycle length in the United States was about 6.25 years, according to the National Bureau of Economic Research. However, these cycles vary in length and are tough to accurately predict. For example, the market cycle ending (peak to peak) February 2020 lasted just over 12 years. The same peak to peak measure ending December 2007, in comparison, lasted almost 8 years.
In fact, when we consider the commonly understood metric of a recession (two consecutive quarters of economic contraction), we find that it can be rather arbitrary and should not always be a cause for alarm bells. It is often exceedingly difficult to capture the patterns and underlying reasoning that results in prolonged contraction (has aggregate demand fallen below supply, is the wider economy adjusting to depressed supply levels, have supply and demand interacted in a way resulting in a “low growth trap1“?). Furthermore, the interplay of lagging indicators and leading indicators leads to further complications in attempting to neatly label an economic period.
Investors should not get too attached to “4-5 year market cycles” as is the commonly held belief in the investment world. Instead, investors should adopt a longer-term view of investments and subsequent returns; not defining the cyclicality of the economy using pre-determined, fixed timeframes. In fact, we have lived through numerous business cycles defined by abnormal length in the last 150 years. Since 1990, these cycles have had an average length of about 10 years.
Rather than dwelling on historical performance over the past four years, investors should focus on future-proofing their portfolios and adopting a forward-looking approach. Key principles to guide investor decision-making, extending beyond performance evaluation over fixed timeframes, include the following:
- Strategic Asset Allocation and Diversification: Long-term strategic asset allocation is the key driver of the variability of investment returns. Investors should focus on building portfolios that provide true diversification (i.e., investing in stocks and bonds alone does not provide adequate portfolio stability). This approach serves to mitigate investment risks as effectively as possible, irrespective of the duration or the current phase of the market cycle.
- Understanding Fees: Investors should be mindful of fees to maximize net returns (the investor is exposed to all the risk and thus, should enjoy the entirety of the return, when possible). This does not always mean looking for the lowest-fee option, but rather ensuring that the fees are justified. For example, it may be beneficial to minimize fees in asset classes with low return dispersion (e.g., bonds) or in efficient asset classes where most active investment managers underperform the market index (e.g., U.S. large cap equities). On the other hand, higher fees in some private asset classes may be justified, where manager skill is key to ensuring superior returns and effectively managing risks. In these asset classes, such as infrastructure and private equity, the complexity and hands-on nature of investment strategies often necessitates specialized expertise, justifying the higher fee structure associated with these investments.
- Transparency of the Investments: Investors should feel that they are not investing in a black box, in which they cannot understand the underlying securities/strategies, or they are not given enough information to make a confidently informed decision.
- Key policy and monetary decisions: It is well understood that these policies are major determinants of the length and shape of business cycles. Even good intentioned policies can have adverse effects, such as those during the “Stop-Go Cycle2” of the 1960s. Adversely, policy decisions can stabilize a market cycle and dampen fluctuations, such as those during the 1992 – 2007/8 expansionary period3.
Thus, getting caught up in, “it has been “x” number of years, and thus my returns should be trending like ”y”, can be frustrating for investors and is not consistent with economic history.
Rather, investors should have a measured degree of patience and evaluate performance with a long-term lens, including both the up and the down cycles; and not be tied to a rigid timeline for market cycles.
- A low growth trap is often characterized by weak investment, slowed/dampened trade (this could be a supply or demand side issue), and low productivity and wage growth.
- Adopted primarily during the “British Economic Golden Age” (1951-1973), the Stop-Go strategy uses deflationary (Stop) and inflationary (Go) measures to cut inflation and attempt to maintain full employment and is generally seen as a short-term strategy. As a result, the government was always contributing to economic instability by being reactionary (always lagging behind the booms and recessions) while also deepening the balance of payments deficit.
- An example of this would be Alan Greenspan and the U.S. Federal Reserve lowering their benchmark rate 11 times after the dot-com bubble to dampen the resulting recession. This, adversely, encouraged unsustainable lending practices and a credit bubble that played a massive role in the lead up to the 2008 financial crisis.
Operations Improvement Specialist