Are we at the dawn of this business cycle’s last inning?
The pundit consensus is for a slowdown but not a recession. The U.S. Fed seems to agree. However, the Bank of Canada’s recently released quarterly business outlook survey shows that Canada’s business sentiment has taken a sharp downward turn with the outlook looking cooler than economists anticipate.
Who is right?
Rather than drawing conclusions based on standard economic statistics, I prefer to focus on two market-related and more forward looking metrics.
The first metric is the well-known seasonal effect in the financial markets, which, in my opinion, has had a better success in forecasting recessions in the past. It relates to the adage “sell in May and go away,” which argues that stock markets do better in the November to April period than in the May to October period.
My research shows that stocks have experienced a positive return in the November to April period in 52 out of the 61 years of my sample (1957-2017) and a negative return in only nine years.
Out of the nine negative return years, seven years (1960, 1970, 1973, 1974, 1982, 1990, 2000 and 2008) were recession years. That is, the November to April period has been dominated by positive stock returns, except during recessions when returns turn negative - in recessions or bear markets, no semi-annual stock return seasonality is generally documented.
By way of comparison, stock returns in the May to October period were negative in 25 out of the 61 years, and only three of these years were recession years.
The data comes from the Canadian Financial Markets Research Centre database at Western University and the index used in the calculations is the Equally Weighted CFMRC index.
At the outset of 2019, I was afraid that we were not going to avoid a recession in the year as the Russell 2000 was down 12 per cent since the end of October 2018.
November to early January stock returns were giving pessimistic signals about the economy. In the following three months, however, the markets recovered strongly. Russell 2000 is now up about 3 per cent since the end of October 2018. The stock market recovery in recent months indicates that, based on this metric, we have marginally avoided a recession.
The second metric has to do with the relationship between the so-called value premium (namely, value stock returns minus growth stock returns) and economic growth going forward.
To separate value from growth stocks, Dartmouth University professor Ken French sorts NYSE stocks by price-to-book (P/B) from low to high, forms quintiles of stocks and calls the lowest quintile value stocks and the highest quintile growth stocks. Then within every value and growth quintile, he sorts stocks by a measure of operating profitability (OP, defined as annual revenues minus cost of goods sold, and selling, general, and administrative expenses divided by book equity) and forms OP quintiles from low to high. And he, finally, calculates value weighted annual returns for each of the 25 portfolios, which my ex-student Howard Ma, a portfolio manager with Meritocracy Capital Partners, made available to me.
Using this data, the adjacent graph plots the difference in the 3-year average annual returns between the highest OP value and lowest OP growth group of stocks.
A number of points can be made from the adjacent graph. First, in the long run, value seems to beat growth as there are more positive numbers than negative. Second, value does not beat growth all the time; there are periods of extensive underperformance of value stocks, as late 60’s – early 70s and 2012-2018. Third, the so called value stocks have been really beaten down as never before in the 2012-2018 period. Fourth, values stocks have started to outperform growth stocks starting in November 2018 on a 3-year annualized average basis. That is, between March 2016 and February 2019 value stocks have beaten growth stocks by a whopping 20 per cent. Finally, and most importantly, the inflection point at which value starts to beat growth seems to be happening at the start of a recession.
It seems that the rising trend in interest rates over the last couple of years may have made consumers and investors more cautious with their money likely setting the stage for an economic slowdown or even a recession as a self-fulfilling prophecy. This behavior seems to have also coincided with a positive value premium. This is exactly what happened at the end of the past two business cycles, as well.
In recessions, growth stocks seem to be hardest hit as optimistic growth expectations are cut back hurting them more than value stocks, and so it may be that the value premium rises during recessions not because value stocks do better, but rather because growth stocks do worse.
No matter what the reason is, the fact remains that sustained change in outperformance from growth to value seems to be happening mostly when the economy goes into a recession. If this historical experience repeats itself, then the adjacent graph seems to side with the BOC’s survey results that the economy is cooler that many economists believe it to be, so much so that we could, in fact, be already in a recession.
Which metric should we believe? Are we going into a recession or not? As it is normally the case in investing, you may have to judge for yourself.
The Globe and Mail
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.