A new study offers encouraging results for a strategy of monitoring the business cycle as a tool for enhancing investment returns (or at least limiting losses). “Over the period 1970-2015, investment returns were enhanced by merely knowing concurrently whether the economy was in a state of expansion or contraction, and making the most basic asset allocation decision of whether to be in stocks or bonds,” write a trio of professors in a recent paper (“Does it Pay to Forecast the Business Cycle? A U.S. Update and an International Perspective”).
The results aren’t terribly surprising. As the authors note, probing the potential for using the economy’s ebb and flow as a signal for adjusting equity allocations has been studied previously. A 1991 article in The Journal of Portfolio Managment (“Does it pay stock investors to forecast the business cycle”) by Professor Jeremy Siegel, for instance, found that “stock returns can be significantly enhanced by successfully forecasting business cycle turning points.”
The new paper, written by James A. Conover at the University of North Texas and two co-authors, updates the analysis through 2015 and expands the focus to foreign markets/economies to supplement the US-based results. The main takeaway:
In the United States, an annual excess return of 2.01% was earned by investing in stocks during expansions and in bonds during contractions. In eight foreign markets, the average annual excess return from the same strategy was 1.74%.
The authors also note that “forecasting business cycle troughs is more important than business cycle peaks” and “even investors who invested one month after the cycle turns could still earn excess returns.”
There are caveats, of course, starting with the simple-but-always-relevant warning that backtested strategies tend to degrade in the out-of-sample results. Nonetheless, the new study highlights a fundamental fact: risk premia fluctuate, sometimes dramatically, and a key (arguably dominant) reason is bound up with the business cycle. We must manage expectations in terms of what this insight can provide, but neither can we afford to ignore this fundamental fact.
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