“It’s the economy, stupid” is the often-cloned phrase coined by James Carville, a strategist in President Bill Clinton’s 1992 campaign. Politics aside, this is very true in the investment world. While it might not always seem like it, the markets are the scoreboard for the economy. According to Ray Dalio, the founder of Bridgewater, the largest and most profitable (in dollars) hedge fund, the best predictor of asset class returns are economic growth and inflation. Economic growth and inflation go through periods of acceleration (sometimes simultaneously) and deceleration. The ebb and flow of growth and inflation determine the business cycle. If you get the business cycle right, in our opinion, you get the market cycle right.

Business cycle illustration; source: WealthShield; as of May 2020

The authors of this paper, Clint Sorenson and Luke Vernon dig into the US business cycle to observe economic growth and inflation trends throughout the cycle, use these observations to determine what factors and investment exposures may perform best in each phase, and test a simple system of adapting a portfolio allocation given the observed business cycle.

Their goal is to develop and test a potential investment system, to eventually use in the “real world,” using leading economic or business cycle indicators. A leading economic indicator (LEI) less than zero and accelerating could be identified as in the recovery phase, greater than zero and accelerating could equal an expansion phase, greater than zero and decelerating could mean a slowdown, and less than zero and decelerating means that a contraction is probable. To test an investment system, the authors hypothetically “invested” in a momentum factor when LEI year over year was above zero and “invested” in low volatility equities when LEI was below zero. They hypothesize that allocating according to the business cycle and rotating the factors will outperform the broad market and “buying & holding” factors in isolation. This test was determined to be successful, delivering over 5% per year in return above the broad market, lessened the maximum peak to trough loss (drawdown) by 16%, and provided more positive return years than the benchmark.

We believe this test demonstrates the importance of understanding where we are in the business cycle and making investment decisions based on that information. This has become an important piece of the investment framework for WealthShield and Sound Financial. Mark Twain once said, “history may not repeat itself, but it often rhymes.” Measuring data, gather and researching the facts, and comparing these to past events are some of the keys to investing money wisely. This rules-based approach helps prevent us from letting emotions drive our decision making and we believe puts our clients in a strong position to reach their financial goals.

Investment Advisory Services offered through Sound Financial Strategies Group, LLC (”Sound”), a Registered Investment Adviser. Certain representatives of SFSG are also Registered Representatives offering securities through APW Capital, Inc., Member FINRA/SIPC, 100 Enterprise Drive, Suite 504, Rockaway, NJ 07866 (800)637-3211. SFSG and APW Capital are separate and unrelated companies.
Hypothetical performance results are intended for informational purposes only to show performance had the model portfolios been used over the relevant period of time without any limitations or restrictions. There is no guarantee that the hypothetical results can be replicated. The results do not account for the material economic and market factors which may have reduced gain or increased losses if Sound or the authors were actually managing client assets. The hypothetical returns assume that no strategic shifts were made during the time periods presented, with the exception of monthly rebalancing using the original allocation percentages Hypothetical results inherently have limitations and thus might not be indicative of actual results. Sound cannot guarantee that hypothetical model portfolios will actually achieve their objectives. The securities or strategies reflected in the model portfolio may not relate or relate only partially to the services offered by Sound. Actual results may vary. The model results do not reflect deposits or withdrawals that might reduce gain or increase losses.
The opinions expressed are those of Sound. The opinions referenced are as of the date of publication and are subject to change without notice. This information is not a recommendation to buy or sell a particular security or to invest in any particular sector. Past performance is not indicative of future results. Forward-looking statements are not guaranteed. All investment strategies have the potential for profit or loss. Sound reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs, and there is no guarantee that its assessment of investments will be accurate. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. This information is not intended to be investment advice and does not take into account specific client investment objectives. Before investing, an investor should consider his or her investment goals and risk comfort levels and consult with his or her investment adviser and tax professional.
Sound is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Sound’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. SFS-20-114
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