Different kinds of stocks perform differently during the business cycle. This is because markets tend to “fear the worst” when recessions occur and “hope for the best” when economic expansions are going on. This means that economically sensitive segments of the market typically get crushed during contractions and then bounce back strongly when a recovery is anticipated.
The mega funds that dominate long only fundamental equity investing don’t care a lot about these business cycles. Their “holy grail” is high “quality” which is defined by sustainably high returns that can be compounded over many years. These quality companies typically are not stressed by economic downturns so investors are happy to stay pat.
However, for traders and other investors that are more nimble the business cycle provides repeatable opportunities.
Economically sensitive stocks include value (low growth), small capitalization and cyclical stocks. These stocks are characterized by weaker balance sheets, high operational leverage and low market liquidity; they are also poorly covered by Wall Street and have less-acclaimed management.
In emerging markets, investors have plenty of opportunities to harvest returns from the business cycle. These markets have more and deeper economic downturns, and, also, greater variability in liquidity flows. Liquidity will dry up entirely during downturns and then ramp up giddily during the good times.
The past year gives a typical example of this investment cycle playing out in real time, just as expected. The chart below shows the performance of the Ishares EM small caps ETF relative to the EM Index. Small caps underperformed sharply when the recession began in February of last year, and then bounced back strongly as recovery was anticipated. Normally, this outperformanse persists into the expansionary phase of the business cycle which for EM should persist well into 2022. Out-performance for the past twelve months is now 25%.
We see the same thing on a country-by-country basis. The charts below show performance of small caps relative to their country index for China, India and Brazil. The Chinese recovery is by far the most advanced of the three. In fact, Chinese authorities already are in a tightening mode, so we can say that this business cycle is well into the expansionary phase. Therefore, time may be running out on this trade. Chinese small caps outperformed the China index by 29% over the past year, so this trade has already been fruitful.
The India chart looks the same: a deep drawdown followed by steady performance. The Indian economy is still far from entering the expansionary phase so this trade may have a long way to go. Indian small caps have out-performed the India MSCI index by 36% over the past year.
Finally, the Brazilian chart also looks the same. Like India, Brazil has not yet entered the expansionary phase so this trade may have legs. Brazilian small cap stocks have now outperformed the MSCI Brazil index by 25% over the past twelve months.
