Stock markets and economic cycles need not move in step

Hitesh Thakrar, manager of New Star Global Equity Fund: Profits are in decline, house prices are tumbling and the 0.5% decline in the UK economy in the third quarter means to all intents and purposes that the UK is in recession. If times are getting tougher for businesses, surely the stock market is better avoided?

This might be true if the economy and the stock market cycle followed a simple cause and effect pattern - declining company earnings leading to declining share prices and vice versa. Events of the last few weeks show the stock market being highly reactive and would seem to support such a view.

In the medium to long term, however, stock markets look to the future. If investors perceive a company will be successful they will rush to buy its shares and bid up the price, even if earnings have only just begun to tick up. Similarly, if investors believe a company will get into difficulty, they will head for the exit, even if the fall in earnings is some way off. In the equity markets no-one wants to miss out on strong gains nor be left standing when the music stops.

What is true for an individual company can be translated to the whole market. The UK stock market peaked last autumn and, bar a few rallies, has been falling for more than a year. It has proved a far more effective and accurate forecaster of the impending recession than the authorities. The good news is that if equity markets are quick to price in a recession, they are also traditionally good at predicting an economic recovery. So when might the turn-around come? In order to anticipate the bottom of the market it is useful to consider how equity markets have behaved in the past so that we might have a window on the future.

Evidence gathered from past recessions supports the case that stock markets recover before the economic statistics can reflect the improvement. Data back to 1855 suggests that an average recession lasts approximately 18 months, although more recent recessions since the 1940s have lasted only 10 months. In these episodes, stock markets have tended to bottom four to six months before the end of the recession.

So, if we assume that the current economic crisis in the US started in December 2007, the US stock market could potentially bottom in the first quarter of 2009. The UK probably entered its recession this summer suggesting a bottom in the market later next year.

While the markets may bottom next year the effects of the recession are likely to linger and it is worth investors considering what this may mean for their portfolios. In the first instance, it pays to play safe. Defensive markets and sectors have traditionally outperformed more cyclical markets and sectors during a recession.

The US is traditionally viewed as a safe haven during times of global economic stress and this yardstick is beginning to reassert itself as emerging markets tumble. The decoupling argument - that emerging markets could be unaffected by the economic cycles in the industrialised countries - always had a hollow ring to it. Analysis of the technology industry reveals that the supply chain of the west is highly integrated with the Asian consumer electronics and manufacturing sector. A significant proportion of Asian production is export-orientated so the slowdown in developing countries is leading to factory closures in China. It is little wonder that emerging markets are down 51% in sterling terms since the start of the year, compared to a 23% fall in the US.

What is true for emerging markets applies equally to other countries that are heavily dependent on their export sectors. In such circumstances, Germany and Japan would be considered cyclical markets and to be avoided, whilst the US, Switzerland and the UK would have more defensive qualities. It is possible to extend this analogy to sectors. Consequently, defensive sectors such as healthcare and consumer staples would be expected to continue to outperform cyclical sectors such as house builders, media and retail.

A recession often marks a turning point in the relative success of investment styles. A consequence of the credit crunch is that banks have tightened their lending and this has a notable impact on smaller companies, who cannot readily access other forms of capital. The chart below shows that there is a relationship between the lending officer survey in the US, which measures overall lending conditions and the relative performance of larger versus smaller companies. Larger companies underperformed in the last bull market but it is likely to be smaller companies that struggle in the months ahead as there is a lag between lending conditions tightening and corporate defaults.

Source: Datastream

Investors tend also to gravitate towards certainty. This means dividend paying stocks may come back into fashion since dividends ordinarily indicate that the company is generating enough earnings to pay an income to shareholders. Matters are complicated by the uncertainty surrounding banks' dividends but high dividend yielding stocks traditionally outperform low dividend yielding stocks during bear markets. Moreover, in previous years total returns from equities have been helped by share buybacks, which have spread company earnings over fewer shares, boosting the value of each share. Many companies are now conserving cash and are limiting their buyback programmes. In such conditions, those companies that can still afford to proceed with their share buy-back programmes will stand out from the crowd.

Similarly, investors tend to be to be prepared to pay a premium for earnings growth during an economic downturn, which should support growth stocks. Growth stocks are companies that are less reliant on the economic cycle for their sales. Good examples are technology companies or pharmaceuticals bringing a new product to market or companies operating in a sector that is independent of economic direction such as those working on government projects.

Clearly, this is a lot for investors to bear in mind but that is one of the problems of a shift in the economic cycle; it tends to upset existing trends. One trend that is unlikely to change, however, is the equity market remaining a forecasting tool. Equity markets have in the past bounced back more quickly than the economy and this trend is likely to continue.