Calibrating cycles: Why life and market cycles don’t always align and what to do about it

3 minute read

Walk into any investment firm’s quarterly meeting where they are formulating their house view or looking at their optimal asset allocation, the question invariably comes up: where are we in the cycle? It’s a good question to ask. You want to be cautious when markets are overly optimistic and aggressive when opportunities present themselves.

Clients see things differently, however. Where you are on your retirement journey should be a more important driver of asset allocation.

This is prudent. At a young age, you want to maximise long-term growth; balance your risk profile in the consolidation phase; and in retirement draw down income sustainably and try to maximise the legacy you pass on.

So how do we best calibrate our own personal cycles with that of the market? The outcomes can be vastly different depending on which approach you use. There have always been smart-sounding reasons to sell out of equity markets, and when proffered by credible experts the siren calls foretelling a market crash can be overwhelming. In contrast, others will point to the fact the US stock market has never delivered negative returns over 20-year holding periods. It would appear heeding market signals or ignoring them altogether can both have merit.

I see three potential ways this dichotomy can be resolved. It requires specifying the nature of returns, the time horizon of returns and the universe of returns.

First, let’s take the nature of returns. By dissecting total returns into its primary components of capital growth and income, the problem to solve can be framed for both the market cycle and the life cycle. Start by targeting a high level of income. A high level of income benefits clients in the lead up to, as well as through, their retirement. Younger investors can compound towards retirement, and older investors can leave their capital in place to grow over the long term while drawing down the income.

This approach significantly reduces sequence of returns risk; a crystallisation of losses as a result of selling down shares when asset values are depressed. To give an example, if you assumed equity markets would deliver 10 per cent on average over the next 30 years, there is a misperception a client drawing down a significantly lower amount, say six per cent, would be okay in retirement. However, they might not be.

From 1973 to 2008, the S&P 500 delivered an average annual return of ten per cent. An investor drawing down six per cent would have been okay. But had the sequence of returns been in reverse, still 10 per cent on average but just in a different order, the individual would have run out of money after just 16 years. This is because following a market correction you do not have enough shares to recover as you have been selling down to fund your income needs.

Without knowing what the future sequence of returns will look like, a focus on delivering natural income first and foremost from dividends and coupons is of paramount importance. From the asset allocator’s perspective, the fund manager can assess prospective returns and, depending on opportunities in the market, aim to maximise long-term capital growth because near-term needs are being met by income. In other words, they need to be fully aware of the clients’ life cycle, while balancing the demands of the market cycle.

Second is the time horizon of returns. As alluded above, the way to think about it is near-term and long-term needs. Here again the primary antidote to near-term needs should be to focus on income. For long-term goals the emphasis should be capital preservation and preferably capital growth.

Unfortunately, while investment managers should be spending time calibrating investment cycles and life cycles, the Information Age means we spend more time calibrating news cycles and performance cycles, neither of which are very beneficial to long-term returns (and therefore outcomes).

Looking at emerging market corporate bonds over the last ten years, for example, over one calendar year half of the returns are due to changes in valuation and half from coupons. But once the holding period goes out to three years or more, changes in spreads only contribute 20 per cent. The bulk of returns, the remaining 80 per cent, comes from the income or carry component. Moreover, according to data from JP Morgan, 97 per cent of returns come from income over the full cycle. Focussing on income is the primary long-term driver of returns and is a better approach to investing as opposed to speculating on near-term prices.

Third is the universe of returns. In order to effectively calibrate market and life cycles, the larger your opportunity set, the more tools you have to help you cope.

Most investors tend to think about the investment cycle in blunt terms, for example where equity markets or bond markets are. However, it is better to focus on where individual companies and sectors are in their cycles, then determine which of those can be harnessed most appropriately to calibrate investment outcomes with clients’ needs and their life cycles.

Consensus forecasts has the earnings growth for the S&P slowing to 12.7 per cent this year, and further slowing to six per cent next year. But many income-generating companies within that market are on a different trajectory. US REITs worked through higher supply last year, particularly in the healthcare sector, and FFO forecasts (an indication of REIT cash flows) are currently accelerating. Consensus forecasts for semi-conductor earnings are also at cyclical lows and encouraging signs have started to emerge. Consensus earnings-per-share growth for this year at leading semi-conductor manufacturer Texas Instruments suggests earnings will decline by 8 per cent, but next year growth is set to resume at close to double-digit levels. The key point is that investors who generalise about the trajectory of the earnings cycle might miss opportunities for re-accelerating growth.

There will always be a slight tension between market and life cycles. The whims, and often randomness, of the market can conspire to make life hard for investors as they navigate the journey towards retirement and beyond. Increasingly, it will be those providers and fund managers who can best align clients’ understandable demand for stable income that provide the best outcomes. This ultimately will require a deeper understanding of the nature, time-horizon and universe of returns.

This article originally appeared in Money Observer.