U.S. Business Cycles drive Global Equities Asset Allocation Investment Strategy

The popular saying: "when the U.S. economy sneezes the rest of the world catches cold" was scientifically proven by a number of studies (see for example Dahlquist/Harvey or Jean Imbs). The impact of the USA business cycles on the U.S. stock market is well understood but its synchronization with the world economy and international stock markets is less appreciated by the investment community.

The relationship have significant implications for the formulation of a successful global asset allocation strategy. It emphasizes the need for a robust U.S. business cycle forecast when designing global equities investment portfolio. And it shows that international equities are not a good hiding place when U.S. stocks suffer a major fall.

In this context, it can be argued that the first and most important step in the development of a global equities asset allocation strategy should be to forecast the U.S. aggregate Corporate Profits - a crucial leading indicator of the USA business cycle.

International stock markets follow Wall Street

We begin with a brief look at two decades of the major international stock markets relative performance.

Correlation between the USA (red line) and international stock market returns is especially apparent during major falls on Wall Street in 1987, 1990, 1998 and 2001 indicated by arrows. Curiously during the major corrections, the international markets dropped deeper than the U.S.

The international markets often disregard the state of their own economies and profit cycles to follow leads from Wall Street. In doing so, investors are acknowledging the power of the world's largest economy. The USA economy is participating in a large part of the international trade and major turns in the U.S. economic cycle are expected to impact on the whole world.

Of the major stock markets outside the U.S. only Japan, the second largest economy in the world, sometimes runs on its own independent business cycle. However, analysis by BusinessCycleInvestor.com showed that often even Japan could not resist a strong lead from the U.S. stock market.

Global Asset Allocation and Business Cycles - empirical research

Magnus Dahlquist and Campbell Harvey in "Global Tactical Asset Allocation" provide a scientific evidence of the observed relationship between the U.S. business cycle and global stock markets. An extract follows (p.8):

Exhibit 3 shows two average returns for each country using MSCI data through November 2000. The first is the average return (in U.S. dollars) during the months that the U.S. was officially in expansion (trough to peak). The second is the average return during the months that the U.S. was officially in recession (peak to trough). The exhibit is rather dramatic. For the U.S., average returns during recessions are about one third of the level during expansions. This is not surprising. What is dramatic is the impact on other countries. While average correlation would suggest some diversification benefits for international investment, Exhibit 3 shows that there is no where to hide from a U.S. recession. In almost every country, the difference between expansion and recession average return is more acute than the U.S. difference. Put differently, other countries’ equity returns are more sensitive to the U.S. business cycle than the U.S. equity return!

What about the other inputs for asset allocation? Exhibit 4 shows that volatility is greater during U.S. recessions in almost every country. This makes some sense because with declining equity values, the market leverage of each country increases.

____End of the extract from Dahlquist/Harvey.

Business Cycle influences Firm Valuation

Value of a firm today is equal to the discounted expected future cash flows. Hence, the variables required to do a valuation include forecast of the cash flows and an estimate of a discount rate consisting of risk free rate, market premium, relative risk Beta, capital structure leverage and nominal interest rates structure. The valuation variables are difficult to forecast with certainty as they are all influenced by the stage of business cycle. Consequently any valuation, intentionally or not, involves a judgment about the stage of the business cycle.

Lets consider in more detail the influence of business cycle on the valuation variables.

Future Cash Flows move with business cycles

The cyclicality of the whole economy naturally implies cyclicality of the industry sectors and individual firms. There are times of economic expansion when it is easy to make a profit and times when most businesses are struggling during economic contractions. And all that cyclicality is by and large independent of the actions and business decisions by individual firm's management.

Discount Rate depends on the stage of business cycle

The evidence suggests that at business cycle peaks, the market risk premium is lower then at the business cycle troughs. At business cycle troughs, investors are short of cash leaving them little for equity investing.

Companies risk exposure changes through time due to the cyclical performance of the industries.

Firm’s capital structure plays a role as risk will increase with higher leverage often associated with the stage of business cycle.

Interest rates are cyclical and each cycle is different so often the entire term structure of interest rates is used for the purpose of estimating discount rates and consideration is given to forecast of cyclical variables: real interest rates, economic activity and inflation.

Corporate Profits signal major turns in the business cycle and stock market

Research by the National Bureau of Economic Research (see for example "Business Cycles – theory, history, indicators, and forecasting" by Victor Zarnowitz) identified Corporate Profits as one of the leading indicators of the business cycle. Historically Corporate Profits lead GDP by 6 to 24.5 months - too wide a range to be an accurate indicator for stock market investors. Each cycle is different making accurate Corporate Profits forecasting very difficult.

Research by George Bijak at Business Cycle Investor resulted in development of a proprietary methodology that improves the accuracy of the Corporate Profits forecast. The Profits forecast is crucial because the U.S. equities are strongly linked to their movements. In fact, there was a 93% correlation between the aggregated U.S. Corporate Profits and the Dow Jones Industrial Average Index (DJIA) over the past 56 years. The chart below illustrates the relationship: Corporate Profits (blue line) are clearly aligned with DJIA index (black line).

Conclusions

Implications of the discussed research for global equities asset allocation investment strategy are significant:

A successful global asset allocation investment strategy must include a careful consideration of the state of the US business cycle and forecast of the Corporate Profits - its leading indicator.
During a downturn in the U.S. equities, reallocating funds to international equities would not provide an adequate protection; in fact it would be likely to magnify the losses. Investors seeking to maximize returns during economic slowdown in the USA should look for opportunities in bonds and real estate or safety of cash instead.
A major upturn in the U.S. equities market is likely to be associated in the early stages with a good performance of major international equity markets.
Valuation of larger firms, both in the US and foreign, should take into account the stage of the business cycle of the USA economy.

References

1. Magnus Dahlquist and Campbell R. Harvey, "Global Tactical Asset Allocation", Social Science Research Network (SSRN) http://ssrn.com/abstract=795376

2. National Bureau of Economic Research - U.S. Business Cycles Dates http://www.nber.org/cycles.html

3. Victor Zarnowitz, "Business Cycles – theory, history, indicators, and forecasting", National Bureau of Economic Research http://nber.org

4. Jean Imbs "Trade, Finance, Specialization and Synchronization", International Monetary Fund Working Paper 03/81 http://www.imf.org/external/pubs/ft/wp/2003/wp0381.pdf

5. Business Cycle Investor
www.BusinessCycleInvestor.com