Investment offices teem with daily data releases and economic news bites. Afternoon market round-ups attribute the day’s movements to whatever data points best fit the narrative of the day or week. Investors crave the narrative, eagerly awaiting the next market moving release.
Lately financial news has inundated us with talk of global slowdowns, trade wars, yield curve inversions and negative interest rates. All of these messages are wrapped in a message of fear around the next recession….which, they say, could be just around the corner.
An investor could be forgiven concluding that the financial markets and the economy are joined at the hip. Evidence doesn’t support such a claim, however. Neither does it support that there is no meaningful relationship between the economy and the markets. We invite you to take a deep dive with us into the real connection between the economy and the financial markets. Let’s start with some historical perspective and proceed to reasonable applications in future posts.
Our hope is that you will find the discussion informative, open-minded and ultimately a guiding light amid the noise and distraction that can easily fill our air waves and invade our screens.
Daily and weekly economic data dumps provide little more than noise and confusion for the long-term investor. Researchers and practitioners alike have attempted to link macroeconomic data and trends to financial market returns and volatility. These efforts consistently find no linear relationship between economic data and financial market volatility and returns. Stock market returns and volatility, though, are conditional upon the phase of the business cycle.
William Schwert (Schwert, 1989): “Estimates of the standard deviation of monthly stock returns varied from two to twenty percent during the 1857 to 1987 period.” These variances are neither random nor regular. Rather they relate to identifiable cyclical periods in the economy.
Schwert continues to analyze many potential factors in stock market volatility, ultimately finding “…the percentage increases in volatility [of stocks] in recessions compared with expansions are large…up to 277 percent in 1920-1952 using daily estimates of volatility.”
In their 1996 article in the Journal of Applied Econometrics, Hamilton & Lin write, “stock returns are difficult to forecast, but squared stock returns are not. Scores of studies have documented …that stocks are much riskier investments at some times than others.”
Hamilton & Lin ultimately provide further support for Schwert, concluding:
“Even though recessionary periods account for only about 16% of the observations, they account for 68% of the total variability in stock prices.”
Eugene Fama and Ken French (1989) posit that the link between business conditions and asset returns may be attributed to the idea that poor business conditions require higher returns in order to induce would be spenders to invest instead of consuming. Perhaps related, they suggest that stocks and bonds may simply carry greater risk in some periods than others.
When economic growth slows and turns to contraction, for example, revenues decline. Future revenues, profits, customer demand, inflation (deflation) create uncertainties that make the fair value of a company debatable and difficult to decipher. Growth investors become disinterested. Trend investors pause. Value investors likely are priced out of their respective markets. Liquidity dissipates. Volatility rises.
Bottom Line: we find a meaningful, non-linear, relationship between the financial markets and the economy. Which leaves us with the question, what do we do with that information?
Many see fit to ignore the question completely. We do not think such avoidance will lead to preferred outcomes for clients. The more diligent of our advisor friends and colleagues argue that we are compelled to do nothing: business cycles are not predictable in a timely, reliable or possibly even relevant way (we discuss HERE how even reliable coincident indicators for economic contractions are not terribly helpful for investors); moreover, that we must rest on long-term portfolios that incorporate the full cycle of risk characteristics into the portfolio 100% of the time. Furthermore, we must accept perhaps extended periods of portfolio inefficiency.
We agree that making predictions about the market or the business cycle walks a treacherous line. Our research, though, provides an important alternative. We need not make predictions about the economy tomorrow, if we can observe the macroeconomic climate today. Said another way, the right set of observations can provide insight into what we ought to reasonably expect for tomorrow.
To be sure, most often the best solution for an individual investor may be the construction of a long-term portfolio that is designed to weather small and large storms throughout the course of a business cycle.
We believe, though, that we can take that solid foundation of well-constructed, long-term diversified portfolios a step further to increase the efficiency of these portfolios through time, ultimately enhancing client outcomes at important stages in one’s financial lifecycle.
Tune in for the next couple of posts, where we will move from academic papers and history towards a discussion of practical application…it might just be fun!