‘Cyclicality’ is a word that regularly pops up in investing conversations. Economists, analysts and financial journalists talk as though they can predict the future, offering opinions on how close the economy is to reaching tipping point and which stocks are best placed to flourish in any given moment, based on a set of principles that they seldom bother to explain.
Share prices surge, tumble, then often rise again. Students of financial history argue that these swings aren’t random, but instead form part of a pattern, a ‘cycle’ that regularly repeats itself.
Every year, the weather gradually changes course, shifting into different seasons as the earth orbits the sun. Economies, companies and markets are believed to follow a circular path of their own. ‘Cyclical’ is the term used to describe this phenomenon.
What are the different types of cycles and what causes them?
Two main factors are responsible for pushing financial markets through cycles. Firstly, there are investor expectations, which tend to swing back and forth between fiery optimism and extreme caution. Then there is the economic or business cycle, the driver of the real economy, influenced by company investment, consumer spending and banks lending money at affordable rates.
Both of these forces are closely related. “Cyclical developments in one area also influence cycles in others,” wrote Howard Marks, co-founder of Oaktree Capital Management. “Thus, the economic cycle influences the profit cycle. Corporate announcements determined by the profit cycle influence investor attitudes. Investor attitudes influence markets. And developments in markets influence the cycle in the availability of credit... which influences economies, companies and markets.”
Are cycles predictable?
Mr Marks and other highly regarded investors reckon paying careful attention to cycles is one of the golden rules of successful stockpicking. Yet even ardent proponents of this theory failed to pinpoint previous financial recessions, indicating that taking advantage of them isn’t as easy as many commentators suggest.
History tells us that the stock market peaks and starts its decline before the economy rolls over. Predicting when this will happen is no easy task, although there are some guidelines to help us along the way.
The economic cycle is broken down into four distinct phases. Each of them can vary in length, but is accompanied by various useful indicators.
- Early-cycle: The economy is moving out of recession quickly. Gross domestic product (GDP) and industrial production are on the up and interest rates are falling, making money cheaper to borrow and encouraging businesses to build up their inventories again. Company sales and profits flourish as consumers start spending.
- Mid-cycle: As the economy gathers momentum it enters the longer mid-cycle phase, characterised by a more moderate level of growth. Interest rates are low and corporate earnings are at their highest as the effects of building up stock to cater for growing demand come to fruition.
- Late-cycle: Growth starts to stall and the economy show signs of being overheated as central banks hike interest rates to keep inflation – the rate at which prices of goods and services rise – in check. Eventually demand tapers off, corporate sales dip and share prices start to look expensive compared to earnings.
- Recession: Interest rates are at peak levels, corporate profits decline and share prices get pummelled. Companies respond to weak sales by slashing inventories and central banks start to make money cheaper again, paving the way for the next recovery.
It’s evident from this breakdown of the four phases of the cycle that two main forces play a key role in determining corporate profits and the state of the general economy: Capital expenditure, the money companies spend on maintaining, improving and buying new assets; and interest rates.
The capital expenditure cycle
Economists such as Irving Fisher claim that cycles move in tandem with companies’ attempts to match ever-changing consumer demand. Time and time again, businesses eventually end up overestimating appetite, leading their profits to tank and recessions to occur.
When the economy is growing, customers are buying and borrowing costs are cheap, and management teams regularly seek to capitalise by ramping up production. Early success then breeds recklessness.
Before long, a characteristic influx of new competitors get in on the act, joining industry mainstays in pushing supply to the point where it outstrips demand. Suddenly prices fall, return on invested capital evaporates and early debt binges become more difficult to pay off, forcing companies to lay off staff in a last-ditch attempt to stay afloat.
“High profitability loosens capital discipline in an industry,” said financial historian Edward Chancellor. “When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow – perhaps they are equally hubristic, or maybe they just don’t want to lose market share.
“The capital cycle turns down as excess capacity becomes apparent and past demand forecasts are shown to have been overly optimistic. As profits collapse, management teams are changed, capital expenditure is slashed, and the industry starts to consolidate. The reduction in investment and contraction in industry supply paves the way for a recovery of profits.”
This pattern, illustrated in the image on page 30, continues to repeat itself. Yet investors remain transfixed by growth prospects, viewing new entrants, stiff competition, share issues and other signs of companies going for broke to cash in on spikes in demand as healthy signs, rather than red flags.
Future demand forecasts frequently generate greater interest than supply dynamics, even though they are much more difficult to predict and often prove to be wrong. In future, investors might be better off running in the opposite direction to wherever the money is flowing.
One of the most efficient ways to measure excessive investment is to focus on capital expenditure (capex) to depreciation ratios. Alarm bells should ring if a company is splurging much more on new assets than on maintaining existing ones over an extended period of time.
The likes of Reach (RCH), Photo-Me International (PHTM), Sirius Minerals (SXX), J Sainsbury (SBRY), Polymetal International (POLY), ContourGlobal (GLO) and Aston Martin Lagonda (AML) have been particularly aggressive over the past decade. When the capital cycle turns, history shows that such behaviour is unlikely to go unpunished.
Investors can also keep tabs on capital spending efficiency across entire nations to gauge if a potential recession is likely. Capacity utilisation rates measure how far economies or companies are from running at full capacity in a percentage. Historically, a rate of 82 per cent or higher is a sign of trouble.
The credit cycle
Another key takeaway from the four economic cycles is the importance of interest rates. One of the government’s main duties is to strike a balance between coaxing people to spend and preventing rising demand for goods spiralling out of control. Changing the price of money helps policymakers to achieve this tricky goal of keeping economic activity at a sensible level.
When the economy needs a boost, interest rates – the cost of borrowing – are lowered, encouraging businesses and consumers to spend more. Gradually, this cheap flow of money causes inflation to rise, forcing central banks to change tack. Interest rate hikes prompt people to spend less, company revenues to fall and share prices to decline. Eventually they trigger a financial crisis, setting off a new round of the cycle.
The yield curve, an illustration plotted on a chart that shows the returns on US government bonds of varying maturities, is also a good indicator of where the economy is heading. A steep upward curve signals that longer-term bonds, displayed on the right, command a significantly higher yield than their shorter-term counterparts on the left. This is another way of telling us that the rate to borrow money for one day should be less than for loans lasting several years, meaning that investors expect interest rates to rise in the future and for economic growth to improve.
Sometimes, the yield curve can move in the complete opposite direction, forming a downward kink. When short-term yields are higher than longer-term ones, it suggests that inflation is due to fall and that the Federal Reserve will cut rates. That’s bad news – a yield curve inversion is a reliable sign that the US, the world’s biggest economy, is hurtling towards recession.
At present, the yield curve is fairly flat: returns on a 30-year bond don’t fetch much more than one due to expire in a month, while three- and five-year yields are currently lower. This reading implies investors aren’t very confident about future economic growth prospects and believe that consumer spending could soften.
At present, the yield curve is fairly flat: returns on a 30-year bond don’t fetch much more than one due to expire in a month. This reading implies investors aren’t very confident about future economic growth prospects and believe that consumer spending could soften.
How has QE affected cycles?
Economic cycles occur roughly every seven to 10 years. The UK experienced recessions in the mid-1970s, early 1980s and early 1990s, managed to emerge unscathed from the 2001/02 dotcom bubble, then crashed hard in 2008.
Based on this historical pattern, we should be on the brink of another economic meltdown within the space of a few months. But low interest rates and inflation, the by-product of years of unconventional monetary policy strategies, suggest otherwise.
Following the 2008 financial crisis, central banks aggressively bought government bonds and other securities in an experimental program known as quantitative easing (QE). The result was an interesting one.
Many predicted that pumping money into financial institutions would encourage them to lend more to businesses and consumers, stimulating demand and leading to bumper inflation. It didn’t quite pan out that way, partly because numerous banks, grappling with bad loans and toxic assets from the last recession and stricter risk capital rules, hoarded the funds in order to shore up their balance sheets and regain profitability.
QE eroded returns on savings accounts and low-risk asset classes and bolstered corporate cash flows. It’s little surprise then that money mainly flooded into equity markets, rather than the wider economy.
|FTSE All-Share total returns, cash, government bonds, UK CPI since 2010|
|FTSE All-Share total return||UK benchmark 10-year gilt return||UK CPI (%)||BoE base rate (blended annual %)|
Opinions differ on what will happen now that central banks are gradually putting the brakes on their experiment. The general consensus is that it will almost certainly erode investor confidence, as evidenced by subsequent bouts of market volatility, and potentially steer money elsewhere, triggering inflation.
The introduction of unconventional monetary policies has so far led this current economic cycle to run a slightly longer, less spectacular course to ones that preceded it. Predicting how much longer it has to run is anyone’s guess, especially given the ongoing uncertainty surrounding Brexit and US-China trade wars.
At present, soaring profit margins, share prices and merger and acquisition activity, coupled with reports of demand peaking in many industries, suggest the stock market is in its last innings. The general economy looks less overheated, although interest rates, employment figures and prices are steadily climbing.
Historically, equity markets top out before the economy rolls over and recessions occur after money supply is tightened. Only time will tell how this plays out this time around, although investors are right to be cautious.
What sectors/companies are most affected?
Some stocks are more vulnerable to shifts in the economic cycle than others. These companies, referred to as cyclicals in investment circles, tend to generate monster profits one year and devastating losses the next.
Identifying them is a fairly easy task. What can people live without when money is tight, job security evaporates and borrowing costs rise? Food, toothpaste, toilet paper, medicines, water, gas and electricity are viewed as necessities. New cars, holidays, homes, jewels, fashion and fancy technology less so, culminating in weaker sales, earnings and share prices for banks, miners, housebuilders, capital goods companies, tech companies, recruiters, the travel and leisure industry and other producers of discretionary goods and services.
Beta can also be used to gauge a stock’s volatility over the years. The market’s beta is 1.00, so anything with a higher reading typically experiences wilder share price fluctuations. For example, a company with a beta of 1.2 should move 20 per cent more than the rest of the market, soaring ahead when times are good and lagging behind when sentiment is in the doldrums.
Below is a list of the FTSE All-Share’s Top 10 highest beta stocks over a five-year period.
|EnQuest (EN)||Oil & Gas Producers||2.96299|
|Premier Oil (PMO)||Oil & Gas Producers||2.53599|
|Premier Foods (PFD)||Food Producers||2.0396|
|Melrose Industries (MRO)||Construction & Materials||1.92529|
|Ferrexpo (FXPO)||Industrial Metals & Mining||1.83168|
|KAZ Minerals (KAZ)||Mining||1.81968|
|RPS Group (RPS)||Support Services||1.80373|
|Gulf Marine Services (GMS)||Oil Equipment & Services||1.79893|
|ITE Group (ITE)||Media||1.6223|
|Source: S&P Capital IQ|
Are cyclicals worth the aggro?
Buy-and-hold investors are sometimes hesitant to invest in cyclicals, preferring instead to park their money in more defensive stocks, such as utilities, consumer staples and healthcare, because they tend to hold up well regardless of how the economy is performing.
Taking this approach means missing out on bumper growth prospects during the early stages of economic expansion. Only when recession signals start emerging can you expect defensives to outperform the rest of the market. To enjoy the best of both worlds, asset managers advise building a portfolio that contains a balanced combination of high- and low-beta holdings.
|FTSE 350 30-year returns by sector|
|Price return (%)||Total return (%)|
|Oil & Gas Producers||370||1,495|
|Forestry & Paper||210||3,358|
|Industrial Metals and Mining||148||2,089|
|Construction & Materials||185||797|
|Aerospace & Defence||323||928|
|Electronic & Electrical Equipment||338||975|
|Auto & Parts||373||1,293|
|Healthcare Equipment & Services||393||859|
|Pharmaceuticals & Biotech||719||2,149|
|Food & Drug Retailers||264||784|
|Travel & Leisure||323||1,023|
|Fixed Line Telecoms||103||516|
|Software & Computer Services||283||525|
|Technology Hardware & Equipment||-60||-56|
How should we account for cyclicality in valuations?
One of the keys to becoming a successful investor is the ability to accurately determine how much a business is worth.
Earnings and cash are usually what investors look at when weighing up how much they should pay for stocks. When they are consistently steady that isn’t too hard. When they jump all over the place, this process becomes a lot more complicated.
There are several unwritten rules to help investors establish a fair price for cyclicals. One is to avoid relying on analyst forecasts – because countless studies show that brokers pay little attention to cycles.
“Besides generating fees for themselves, the main economic function of the investment bank is to supply finance to capital-hungry businesses – for which they earn generous fees,” said Edward Chancellor. “Bankers are paid to drive capital cycles, not to worry about the negative long-term consequences that capital expansion may have for clients.”
Instead of listening to wild estimates, investors are advised to dig back through old financial statements. Ben Graham, the “father of value investing” and mentor to Warren Buffett, championed this approach, urging investors to calculate average earnings over a decade, the general timeframe of economic cycles.
Hays (HAS) fits the description of a cyclical company. When recessionary pressures kick in, companies lay off staff and stop employing, impacting the workload of recruiters.
Mr Graham’s test yields harsh results. Last year, Hays posted earnings of 11.3p, its highest since before the financial crisis. Its average over the past decade was 7.4p, a less compelling return at the current share price.
To get a clearer picture, investors are advised to examine as much data as possible. Another option is to identify the midway point of return on assets over 10 years and then multiply that figure by the current asset base.
The number that emerges should provide a rough proxy of mid-cycle earnings. Multiply it by a reasonable price/earnings ratio for that stage of the economic cycle and check out how it compares to the current share price.
Is there a case for market timing purchases to account for cyclicality?
Economic cycles follow similar paths, but aren’t always identical. Using them to get a rough gist of which phase we’re in is possible; expecting them to tell you exactly when the next bubble will burst is a pipe dream.
Let’s take the current environment as an example. Big-name investors have been saying for a while now that a recession and bear market are around the corner.
Their concerns aren’t without justification, although few, if any of them, will be able to pin a precise date on when the cycle will turn. If you followed their warnings in early 2016, you’d have missed out on some bumper returns. And if you continue to ignore them, chances are you will eventually get caught out the next time the economy goes belly up.
Difficulty timing the market has led countless investors to sidestep the challenge completely. A popular approach is to choose a strategy that meets personal objectives and stick with it over the long term. Time in the market, rather than timing the market is viewed as a sensible way to ride out short-term bouts of volatility.
Still, that’s not to say that investors can’t do a few simple things to boost returns. Becoming familiar with the economic cycle won’t suddenly enable you to time the market perfectly. It could, however, help tilt the odds more in your favour.
Historically, investors tend to pile into shares later in the cycle when confidence is high and everyone is bragging about how much money is being made. They then proceed to dump them when a recession arrives, right before the next expansion phase is under way. In future, if they still have any capital left to invest, they should seek to do the opposite.