Investors have long used where we are in the economic cycle to decide which stocks to buy and sell. New research from Nomura’s Joseph Mezrich flips that on its head by showing how investors can use stock performance to help determine where we are in the cycle. Too bad the market is sending mixed messages right now.
The back story. Stock markets drifted lower last Friday after one of the key recession indicators—the yield curve between the 10-year and three-month Treasuries—turned negative. Despite the S&P 500’s 13% rally this year, many investors are still feeling unsettled about slowing earnings growth, the possibility of a global economic recession, and a suspiciously dovish Federal Reserve. In other words, figuring out where we are in the current economic cycle has been one of the top issues on everyone’s mind.
What’s new. While it is widely accepted that different stocks perform better during different phases of the economic cycle, Nomura’s Mezrich looked at the performance of different “factors”—industry jargon for specific stock characteristics—to see if it could tell us anything about where we are in the economic cycle.
Mezrich used quarterly growth data from the OECD Leading Indicator Index going back to 1961 to divide the economy into four phases—contraction, slow growth, moderate growth, and extreme growth. He then looked at the average annualized return of five commonly used factors—momentum, value, size, minimum volatility, and quality—and tried to identify how they perform differently throughout these four economic phases.
Mezrich found that while quality and minimum volatility tend to do well in the contraction phases, large-cap stocks do the best during slow growth, momentum shines during moderate growth, and value and small-cap stocks tend to outperform during extreme growth.
During the second quarter of 2018, small-caps beat large-caps and momentum stocks outperformed, while value, quality and minimum volatility underperformed, a pattern that matches the moderate growth phases the most, according to Mezrich. And that’s what happened in the following months, he says.
From the beginning of December through the end of February, however, minimum-volatility stocks have performed the best, and value stocks also outperformed, while small-caps and momentum stocks performed the worst, and quality also slightly underperformed. This pattern matches what has occurred in the contraction phase of the economy on four of the five factors, with quality’s underperformance the lone exception, according to Mezrich. But the pattern also closely resembles what has occurred in the slow-growth phase, he writes.
Moving forward. So which is it? Mezrich thinks quality and minimum-volatility will ultimately inform us where we are in the economic cycle. The two factors are currently showing some discrepancy in performance, with minimum-volatility beating the broader market and quality stocks trailing. But Mezrich doesn’t expect that divergence to last. If quality and minimum-volatility both outperform, a contraction phase is likely coming. If both underperform, on the other hand, it means a slow-growth phase should be on the horizon, Mezrich writes.
Too bad he couldn’t tell us which.
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