A Timely Reminder

Updated: May 16



As the current global business cycle matures, I thought it might be an opportune moment to revisit one of the basic but counterintuitive laws of stock markets, namely that, broadly speaking, the stronger the economic performance, the worse the stock market performance.

"Strong economies are associated with poor returns from risky assets"

Readers of my letter will know that much of my analytical framework around tactical asset allocation is based upon the empirical findings set out in a 2009 paper by Robeco’s Pim van Vliet and David Blitz titled ‘Dynamic Strategic Asset Allocation - Risk and Return across Economic Regimes’. I have found this paper particularly useful because the authors employ what seems to me a sensible methodology. The below extract from the paper helps illustrate that.


“While many other papers use statistical properties of the assets themselves for regime definitions, we propose a more fundamental approach which uses economic data for defining different regimes. An essential feature of our approach is flexibility with regard to the specific set of variables and the model structure that are used. The key difference with the statistical approach is that, instead of providing estimated probabilities of being in a particular regime at any point in time, our approach explicitly identifies the prevailing regime, which enables us to derive transparent regime-based asset allocation strategies. Specifically, we consider a regime model which uses four economic indicators (the credit spread, earnings yield, ISM and the unemployment rate) to identify four phases of the economic cycle (expansion, peak, recession and recovery). Also unlike other studies, we consider a broad opportunity set instead of focusing on the attractiveness of one particular asset class. In addition to equities, bonds and cash we include small caps, value, growth, credits and commodities in our analysis.”


The other key attribute of the methodology is that the economic indicators used to identify the business cycle regime in question are available on an ex ante basis. This means that it can be used more readily in practice, unlike a framework based on NBER (National Bureau of Economic Research) data that is only available ex post.


“The NBER is well-known for determining official recessionary periods. NBER data is of little use for real life dynamic asset allocation purposes though, because the NBER only classifies a period as either expansion or recession after the fact. Because of this hindsight, the NBER data is only suitable for ex post explanatory analyses and not for ex ante decision making. This is also recognized by Gorton and Rouwenhorst (2006), who use the NBER business cycle classification for gaining insight into the risk and return properties of commodities over the cycle. In order to address this concern, we propose an alternative, forward-looking regime indicator. Our indicator uses only information which is actually available ex ante and offers the additional advantage of resulting in a more balanced distribution of observations across regimes.”


However, while van Vliet and Blitz’s paper is useful, it does not offer much explanation as to why certain investment types behave the way they do in each economic regime or phase.


For this, there are two papers which I have found useful. These are Donald Keim and Robert Stanbaugh’s 1986 paper Predicting Returns in the Stock and Bond Markets and Eugene Fama and Kenneth French’s Business Conditions andExpected Returns on Stocks and Bonds, published in 1989. The results of both these papers are consistent with those of van Vliet and Blitz, namely that, roughly speaking, equities do better when economies are weak, and worse when they are stronger. But unlike the latter paper, the two older papers seek to interpret this finding.


Fama and French offer two interpretations: consumption smoothing and a risk-based interpretation. The extract below helps to explain the first of these.


“When income is high in relation to wealth, investors want to smooth consumption into the future by saving more. If the supply of capital-investment opportunities is not also unusually large, higher desired savings lead to lower expected security returns. Conversely, investors want to save less when income is temporarily low. Again, without an offsetting reduction in capital-investment opportunities, lower desired savings tend to push expected returns up.”


In other words, when times are good, investors want to save more, pushing stock prices up and expected returns down. The reverse happens in bad times.


Fama and French use three variables to define the cycle: the dividend yield (D/P), the default rate (DEF), and the term premium (TERM). The aforementioned risk-based interpretation is that these variables are associated with risks that fluctuate over time and that therefore cause returns to fluctuate: In other words, high dividend yield, high default rate, and high term premium (essentially, the yield curve) all reflect higher risks in equities and thus the higher returns that are needed to justify these risks. Whatever the explanation, it is useful to remember that strong economies are associated with poor returns from risky assets such as equities and high yield bonds. As central banks tighten monetary conditions in order to rein in strengthening economies, it makes sense to be reducing risk.


Published in Investment Letter, April 2018





The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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