Timing the Markets According to Business Cycles

In this section, let's understand when a particular asset class performs at its best. 

In our study we have taken a business cycle ranging from October 2002 to March 2009. Within the business cycle the four phases were divided as follows:

Phase I: October 2002 to June 2004

Phase II: June 2004 to June 2006

Phase III: June 2006 to August 2007

Phase IV: August 2007 to March 2009

The cycles post the recession of 2009 were very short. The main reason is monetary intervention. However, in each and every cycle, no matter how short it is, being in the below mentioned asset class should be profitable due to the inherent macro factors shaping the phases.

Equities

Equity markets perform the best during Phase I of the business cycle. Let us understand why?  

Equities as we know are the riskiest asset class due to its nature of receiving the residual claim. This means at the time of bankruptcy, an equity shareholder will receive the money, only after the claims of all the other stakeholders like creditors, banks and even the government are settled. Therefore at the time of recession, when the probability of bankruptcy is at its peak, investors sell equities at throwaway prices. This leads to panic selling and share prices are at dirt cheap levels.

Now once the dust is settled, that is the economy starts to experience green shoots in Phase I, investors should hop on to buy the equities. The risk of the economy slipping back into recession might be there, however, it is priced into the stock valuations.

Let's look at how the asset classes have performed in Phase I. 

Commodity

Commodity prices are directly linked to inflation and industrial demand. Hence, the prices of commodities rise when the demand exceeds supply. We know from our earlier discussion on business cycles, that demand exceeds supply during the Phase II of the business cycle and hence the commodity prices will rise at its best during Phase II. 

Phase III also experiences a rise in the commodity prices, sometimes higher than the levels seen in Phase II. Since inflation is still dominant it supports the price rise, however, dampening industry sentiments. 

Phase III suggests that we should exit long positions from commodities during this Phase.

The following data table supplements our study.

Bond

Bonds are inversely related to interest rates. Bonds will outperform only when interest rates reverse. 

Our understanding of business cycles tells us that interest rates are on a rise at least till Phase II of the business cycle. Phase III however initiates with a  peaking of interest rates. Hence it can be considered that bonds outperform in Phase III and IV of the business cycle.

Within bonds, corporate bonds (investment grade) are the ones that outperform in the Phase III. This is because with falling interest rates in phase III, investors prefer to invest in Bonds rather than equity. Investment grade companies have higher solvency and are not expected to go burst in case of a recession.

During Phase IV or recession, investors should prefer government bonds. This is because during Phase IV the business environment is quite suppressed while RBI will keep on reducing the interest rates at a faster pace in order to stimulate the economy.

The following graph reinstates our study on the business cycle.

Notice the negative bond yield graph signifies reduction in interest rate which means that government bonds must have increased during this period. This is in comparison to equity and commodity asset classes which fell.