Cycles Matter

Cycles Matter

The most important factor regarding your asset allocation is the economic cycle.

The most important determining factor for the return profile of various assets and equity sectors is the direction of the economic cycle. Is the economic cycle trending higher or trending lower?

When the global economic cycle is trending higher, high beta sectors dramatically outperform, long-duration fixed income suffers and equity volatility is generally lower than average. This is a great time to be long of cyclical equity sectors.

Conversely and unsurprisingly, when the global economic cycle is trending lower, a "down cycle," cyclical equity sectors suffer large declines, defensive equity sectors greatly outperform, long-duration fixed income generally rises and equity volatility or "market events" are an active risk.

Since the start of 2018, the global economic cycle has been in a "down cycle" which explains the dispersion in sector performance, the decline in interest rates and the constant volatility in equities including the "market event" in December 2018 which is highly consistent with down cycles throughout history.

Identifying Growth Cycles

The first part of this analysis is defining up cycles and down cycles. We use a signaling process including the length of the decline/rise, the magnitude and the breadth of the move to define the peaks and troughs.

In the chart of the Global PMI below, we identified seven up cycles and eight down cycles, the eight which is currently still underway.

Down cycles are defined by moves in the chart below from A to B while up cycles are defined as moves from B to A.

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Source: Bloomberg, EPB Macro Research, Pervalle Global

Once the growth cycles were defined, we tested the average and median performance of various equity sectors, fixed income positions, currencies, commodities and more.

In roughly 22 years, there were only 15 major portfolio pivots that you needed to make to achieve the best returns, minimize drawdowns by positioning in the correct sectors and beat the averages.

Historically, major portfolio pivots only occured every 1.5 years with some pivots lasting well over two years, far from a short-term strategy and quite reasonable even for long-term 401k investors, long-only investors or tactical long/short asset managers.

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