Over the past few months, we have written about two of our core tenets: 1) Tenet 1: Be intentional about your life, and informed about your money (What’s Your Financial Literacy Quotient). 2) Tenet 2: Seek to manage the risk (the downside) in your portfolio (Risking It All for the Cheese). This month we are discussing our final tenet: strive to “invest in the best,” which involves rotating to areas of the market that have historically tended to perform better based on certain cycles and patterns.
As Mark Twain famously said, “history doesn’t repeat itself, but it does rhyme.” There are never guarantees in this business, but if you are a student of the market, you are likely aware of various “rhyming patterns and cycles.” Alexis Advisors strives to leverage these tendencies, keeping our portfolios focused on the market’s leadership.
We need to stress that these are “rhyming patterns” – that is, they are unlikely to repeat exactly – and there are any number of outlier events that can disrupt patterns or cycles. Unfortunately, given that these cycles “aren’t perfect,” those who aren’t students of the market may chalk these patterns and cycles up to mere folly.
So, with that said, let’s talk about three types of cycles and patterns.
Business Cycle
We discussed the economic cycle a few months ago, but it is worth repeating given many stock patterns are inclined to stem from this cycle.
The economy tends to follow a pattern – what’s called the business cycle. A business cycle begins with a recession, moves into expansion, and then into full recovery where the economy is operating at full capacity. According to the National Bureau of Economic Research, there have been 11 business cycles from 1945 to 2009, with the average length of a cycle lasting about 69 months, or a little less than six years. The average expansion during this period has lasted approximately 58 months, while the average contraction has lasted only 11 months.
As per the chart above, the stock market tends to lead the economic cycle – that is, a bear market will typically start before the economy moves into recession, and a bull market will typically lead the economy out of recession. Barring geo-political or global economic shock, as per the above chart, we estimate that this bull market, though long in the tooth, may still have some room to run before peaking.
Sector Rotation Patterns
Sector rotation is based on the premise that certain sectors do well over time, but not necessarily at the same time. The approach suggests that there exists a degree of predictability (an identifiable pattern) in the relative performance of the ten sectors that most stocks fall into (see chart below for sectors) based on where we are in the economic cycle.
For example, during the early expansion phase, cyclical stocks such as financial, technology, and consumer discretionary tend to outperform. During the recession phase, defensive sectors like health care, consumer staples and utilities outperform because of their stable cash flows and dividend yields.
Once again, it’s important to stress that these patterns can be interrupted by exogenous events. A perfect example of this is the fact that healthcare stocks have been outperforming handsomely since the passage of the Affordable Care Act – even though we were in the middle of an expansionary phase.
Style Rotation Patterns
In the same way that different asset classes (stocks versus bonds versus commodities, etc.) and various sectors tend to perform better or worse at different points in the economic cycle, the same may be said of the six primary styles:
- Large Cap Growth
- Mid Cap Growth
- Small Cap Growth
- Large Cap Value
- Mid Cap Value
- Small Cap Value
Style rotation implies that there may be an identifiable pattern or cycle in the relative performance of the various styles – small, mid or large capitalization stock portfolios, and growth versus value portfolios.
For example, small-cap stocks have historically outperformed large cap stocks during rising rate environments – a rising interest rate environment is typically indicative of an economic recovery or expansion. On the other hand, large-cap stocks tend to outperform small-cap stocks during periods of economic uncertainty – that is, during recessions.
Conclusion
In spite of the potential for outlier events, investors may be able to leverage these patterns in their investment approach. Alexis Advisors strives to do just that – using computer models to help us determine the turning points – when to reduce our position or sell a particular sector or style, and when to add to or buy a position.
Again, nothing is guaranteed in the investment business, and we are fully aware of the tendency to “rhyme rather than repeat”. With that in mind, as quoted by Ned Davis Research, “we strive to stay focused on what the market is doing, not what we think it should be doing” – and always seeking to weigh the potential risk versus reward.
Live well…invest well…
Roberta
Information contained herein is for informational purposes only and is subject to various interpretations and time frames, and should not be considered investment advice. Advice may only be provided after entering into an advisory agreement with Alexis Advisors, LLC (“Advisor.”) Advisor does not assume any legal liability or responsibility for any incorrect, misleading or altered information contained herein. Advisor shall not be liable for the improper or incomplete transmission of the information contained in this communication. Past performance is not indicative of future results while changes in any assumptions may have a material effect on projected results. Third Party Research Disclaimer: Third party research is provided for information purposes only and has not been prepared by Alexis Advisors, LLC. The information contained herein is based upon sources which we believe to be reliable, but no representation, express or implied, is made with respect to the accuracy, completeness or reliability of the information or opinions in the reports. About: Alexis Advisors, LLC is a Registered Investment Advisor with the Commonwealth of Virginia. Advisor’s current Disclosure Brochure is set forth on Form ADV Part 2 and is available for your review upon request. Please contact Advisor promptly if there are any changes in your financial situation or investment objectives, or if you wish to impose, add or modify any reasonable restrictions to the management of your account.