Lessons from 30 Years of Cyclical RotationsBy admin_45 in Blog
When I (Nick) first started covering the autos in 1991 at the old First Boston my first course of action was to meet a slew of portfolio managers and analysts to figure out what I could do to be helpful. As I visited them, I noticed many had a sine wave chart pinned to their office walls. It represented the business/market cycle, and at each part of the sideways S-curve there were sector names. It looked something like this:
- Recession (from the X axis to the low point on the sine wave): Overweight Consumer Staples, Utilities, Health Care, Telecomm. Consumer and business demand for these industries was reliable, so they were good places to hide out going into a downturn.
- Early Expansion (from the curve’s nadir back up to the X axis): Overweight Financials, Consumer Cyclicals. These groups get pummeled in recessions but have fantastic earnings leverage in an upturn.
- Mid/Late Expansion (x axis to the top of the curve and just over its zenith): Energy, Materials, Technology, Industrials. All these industries traditionally needed to see +85 percent capacity utilization to get pricing power and earnings leverage. That only happened late in a cycle.
This was a good paradigm, and pretty straightforward to implement because sector weights were quite similar across the S&P 500 in 1991. You could tweak a bunch of these weightings by 1-2 percentage points and handily outperform:
- Consumer Staples: 15 pct
- Consumer Discretionary: 13 pct
- Health Care: 12 pct
- Energy: 12 pct
- Industrials: 12 pct
- Financials: 9 pct
- Telecomm: 8 pct
- Tech: 6 pct (not a typo)
- Materials: 6 pct
- Utilities: 6 pct
The difference between the largest and smallest weighting in 1991 was 9 points; in 2021, it is 25 points because Tech is now 27 percent of the index and that doesn’t even include Amazon (4 pct), Google (4 pct) and Facebook (2 pct).
Now, this is all pretty cool history and certainly highlights how Tech has eaten the world, but how can we make some money with these observations?
Two ideas on that:
#1: Parts of the 1990s sine-wave playbook still clearly make sense. We’re currently in some mashup of “early” and “late” expansion, if only by the process of elimination. And since cycles take years, not months, we have some runway here. (At least that’s what market valuations strongly imply, so we’ll go with that).
This means one has to, at the very least, underweight Consumer Staples and Utilities. Not only do they miss on leveraging economic recovery, but they’re also yield substitutes in a rising rate environment. If you want to short these groups and buy the index, that’s another way to go make some old-school cyclical returns.
#2: Since Tech is shaky and now underperforming the S&P 500 YTD (+2.1 pct vs. +3.3 pct), we should look to 2000 – 2001 as a case study for where capital goes when investor sentiment turns on this group. We’re not saying that Tech is in a bubble like then, but this period can still be instructive for considering what happens when investors sour on the sector.
Looking at the S&P’s sector weights from March 2000 and March 2001, here’s what happened:
- Tech’s weighting declined by 40 percent, from 32.5 percent to 19.6 pct.
- Over that year the capital freed up by selling Tech went mostly to Financials (13 pct weight became an 18 pct weight), Health Care (10 pct weight to 13 pct), Industrials (8 pct weight to 10 pct) and Consumer Staples (8 pct weight to 10 pct).
- No other group got a meaningful chunk of the immediate post-dot com reweighting.
When you pair these findings with the prior point, you end up with Financials and Industrials as the logical plays since they combine cyclicality with a historical record of reabsorbing capital released as investors scale out of Tech.
Summing up: getting sector calls right this year requires both the old-school approach and an awareness that Tech soaked up a lot of capital last year and some of that is going to leach back out to other areas. I can remember that process vividly from managing money in 2000 and it made very little sense at the time. Bad companies (remember I covered the autos) got better valuations simply because they weren’t Tech names. But that’s the way it worked, and even if net Tech selling just trickles capital back into the system this year it’s logical to think this history will repeat itself on a smaller scale in 2021.