Understanding economic cycles can inform financial decisions
• Following the market’s rise and fall can pay off, but a contracyclical approach may be best
Despite regular academic assurances that economic and market cycles can be mitigated, managed or will even stop happening “from here on out”, the world is still beset by financial panics.
Most recently, we navigated the financial crisis in 2007-08 and the emerging markets collapse, which reached a low point in early 2016.
Howard Marks, co-founder of Oaktree Capital Management in the US, says: “In the world of investing, nothing is as dependable as cycles.
“Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or to profit from the mistakes of others. They are the givens.”
In fields such as the natural sciences or medicine, progress is cumulative: it is built on the foundation of an historic body of work. This may occasionally result in prior beliefs being refuted or refined.
However, the vast majority of work stands to guide and support future innovations.
Progress in the fields of finance and economics appears to be cyclical, rather than cumulative. Economist JK Galbraith said it best: “There can be few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the wonders of the present.”
Many investment managers do extensive macroeconomic research to develop a top-down view of the return prospects for each asset class. They then determine the weightings of the respective asset classes in their multi-asset funds based on this view. In our experience, trying to predict economic and market cycles is a poor allocation of resources and hardly ever improves performance or lowers risk.
The truth is that cycles cannot be forecast. Market tops and bottoms can never be observed in real time — only with hindsight. An investment manager who devotes considerable resources to developing a topdown view generally feels obligated to use it, and may become increasingly confident of its forecast accuracy just as a market cycle matures and approaches an inflection point.
Rather, we believe managers should focus on buying highquality stocks at attractive prices and selling them when they are no longer sound investments (ideally because the price has increased to such an extent that it has eroded the margin of safety previously presented).
This does not mean ignoring big cycles. In fact, they are an important component in delivering long-term returns ahead of mandate targets.
As stock prices rise through the cycle, it becomes more difficult to find good opportunities at attractive valuations. Conviction levels for remaining holdings also decline, dictating smaller positions.
When exiting or trimming equity positions, your cash balance will gradually grow – ready to be deployed when the market once again offers attractive opportunities. The size of this cash balance is therefore determined by the results of a bottom-up process; it is not an asset allocation decision.
Cash expands your investment opportunity set from the asset prices currently available to those that will become available in the future as the cycle works its magic.
When fear or even panic prevails, markets will once again present an abundance of opportunities at low prices.
This may sound like a simple, common-sense strategy, but it is difficult to implement. Firstly, it requires immense discipline to execute in real time. Accumulating cash in a strong bull market inevitably dilutes short-term returns and may mean lagging fully invested competing products for a period.
Secondly, there are always credible reasons for the fear or panic that causes price declines, whether company-specific or related to the market in general.
Conventional wisdom will strongly support selling in such an uncertain environment and purchases are likely to be seen as reckless.
Finally, most multi-asset funds have tight pre-set allocation ranges for each asset class. Cash is typically minimised, given its lower long-term average return. Few investment houses appreciate the substantial intertemporal value of cash and do not have mandates designed to take advantage of it.
Bottom-up investors can also benefit from backing management teams that have demonstrated a deep understanding of market cycles and have configured their businesses to take advantage of cyclical extremes in asset pricing.
Brookfield Asset Management is an excellent example. It is the world’s second-largest alternative manager, with about $250bn of assets under management, and specialises in real assets such as infrastructure, real estate, renewable energy and agricultural land.
Over the past few years it has raised substantial funds in developed markets. This has included placing long-dated debt and perpetual preference shares at low yields (for example, it recently placed $550m in 30-year debt at a yield of 4.75%) as well as selling property investments in London, Sydney and Manhattan.
As a global player, Brookfield also seeks out distressed or liquidity-constrained markets when looking to invest.
For example, in 2016 it agreed to buy Nova Transportadora do Sudeste, a gas pipeline business in Brazil that was a carve-out from the indebted and scandal-ridden oil producer Petrobras. This sort of asset only becomes available at a reasonable price in an environment of extreme fear, which was the case in 2016. By early 2016, the Brazilian real had halved in value in little over a year and the local debt market had effectively stopped functioning.
A disciplined approach to buying low and selling high – regardless of prevailing market sentiment – allows bottom-up investors to capitalise on market and economic cycles. In addition, when evaluating the management teams of potential investments, look for the rare ability to act contracy clically.