You Can Fight The Fed, But You Can't Fight The Cycle

Is buy and hold the right strategy? When the economy turns lower, do you have to suffer through 40% losses in order to adhere to the Buffett disciples suggesting to just keep buying stocks? These are some of the most common questions investors ask on a daily basis.

With the Federal Reserve and monetary policy in focus, these questions have taken the form of popular investing clichés such as "you can't fight the Fed."

This is a repackaged form of advice to stay in the market because you cannot time it. When the Fed is raising rates, the economy is doing well so equities and bank stocks are a great bet. When the Fed is lowering rates, despite the weaker economy, the lower rates will be fuel for equity prices. Sound familiar?

The truth of the matter is that the Fed doesn't matter. You can absolutely fight the Fed or allocate your portfolio in the opposite direction of their monetary policy and in fact, you should. You just cannot fight the economic cycle. You must use the economic cycle to your advantage and as a tailwind in order to outperform over decades of investing.

Using the predictable rhythm of the economic cycle, there is a better and far less volatile way to navigate the chop.


Using Economic Cycles

In a recent note on why cycles matter, which you can read by clicking here, I highlighted seven "up cycles" and seven "down cycles," the seventh which we are currently still in as outlined by the data below.

The cycles, defined using several factors such as the length of the decline, the magnitude of the decline and the breadth (the number of components declining) of the decline are outlined in the chart below. Down cycles are from points A to B and up cycles are from points B to A.
 

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Source: Bloomberg, EPB Macro Research


We can test the performance of various assets as we did in the previous research note during each up cycle and each down cycle. The results are overwhelmingly clear.

During up cycles, the average return for the S&P 500 (SPY) is over 25% while the average return during down cycles -6.3%.

Buy and hold investors don't often realize that virtually all of their gains over time come during up cycles and down cycles simply lower the total return over a lifetime of investing due to recessions, growth-scare induced drawdowns, and volatile markets. You could be using both up cycles and down cycles to your advantage.

It is not uncommon for the S&P 500 to rise during a down cycle as it currently stands with a gain just north of 6% since the latest cyclical inflection point. The cycle is not over, however, which means the classic down cycle risk remains and there are other investments that may be more prudent.
 

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Source: Bloomberg, EPB Macro Research


The return of Treasury bills during up cycles and down cycles is presented below and the return profile is extremely stable as you'd expect. The average return during a down cycle exceeds the S&P 500 by over 10% and there are some cycles in which you could have achieved a greater than 40% outperformance by shifting to Treasury bills during a down cycle vs. staying invested in the S&P 500 or worse, cyclical equity sectors.

There are some cycles, such as 2014, in which you would have earned just 0.3% in T-bills vs. a gain of +4.7% in the S&P 500. This kind of underperformance, or fear of missing a large equity rally, prevents most investors from using the economic cycle to their advance over a lifetime of investing, even when the results are clear.
 

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David J. Tanner 1 year ago Member's comment

Good read.