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The Importance Of Growth Cycles

Aug 20, 2021

Executive Summary

  • The importance of growth rate cycles on asset class performance
  • How to track economic cycles
  • Spotting economic inflection points

The Importance of Growth Cycles

The growth rate cycle is the most important fundamental factor impacting your investment returns, yet so few people understand what a growth rate cycle is, how to track it, and why it should be an essential part of every investor's tool kit.

In this article, I’m going to walk you through just how important growth rate cycles are to your investments and show you how tracking growth rate cycles will help you massively reduce your downside risk while still keeping or even adding to your upside potential.

I’m going to break this article into three main parts, starting by outlining the growth rate cycle and talking about the difference between a cyclical upturn and a cyclical downturn.

Then I’ll get into the major difference in asset class performance during each cycle and show you how the growth rate cycle is responsible for over 90% of all gains in the stock market.

Lastly, I’ll touch on how, at EPB Macro Research, we go about spotting these inflection points or transitions from a cyclical upturn to a cyclical downturn.

The Growth Rate Cycle

The following chart shows what we call a coincident economic index.

This index is a composite or a blend of four major indicators: adjusted real income, industrial production, nonfarm payrolls, and real consumption.

We take the best measure we can find on real income, real consumption, employment, and production, what I call the four corners of the economy, and we combine them into one index.

We can use other measures to track coincident economic trends like real GDP, but that’s reported quarterly instead of monthly and contains short-term distortions like changes in private inventories. 

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Tracking the four major coincident indicators and the aggregate or composite of them all is the best representation of the real economy on a monthly basis.

It’s called a coincident index because the peaks and the troughs coincide with the start date and the end date of recessions.

A leading economic index would peak and trough before the start and the end of a recession, but a coincident index marks the start date and the end date.

Most investors analyzing the economy ask themselves, are we in an expansion or a recession or is there a recession on the horizon? Most investors only focus on recession risk. 

Recessions are very bad for stock prices and home prices; we know that, but why do asset prices vary so much during the expansion periods?

Once you understand the growth rate cycle, you won’t want to know when the next recession will be; you’ll want to know when the next growth rate cycle downturn will start.

All recessions occur during growth rate cycle downturns. Recessions don’t give you enough information. The growth rate cycle is far more informative. 

If we take the coincident index charted above and look at the growth rate, we see that the growth rate oscillates up and down in 1-2 year periods on average, during the expansion years.

This is what we call a smoothed six-month annualized growth rate, so the numbers, like 6% or 2% in the chart below, mean that the coincident index increased at a 6% annualized pace or a 2% annualized pace over the last six months.   

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If we look at the 1990s period in the chart above, we can see that during the expansion, the growth rate radically changed, rising from 2% to 6%, falling back to 3%, and then increasing to 5%.

A similar cyclical pattern emerged during the last economic cycle. We saw growth oscillate from 0% to 4%. Economies move in cycles. 

There’s a lot of monthly chop, but if we see through the noise, there are 12-18 month periods, sometimes as long as 24 months, where growth trends higher or lower but trends up or down.

When the growth rate falls below 0% for a sustained period, that’s a contraction in economic activity, and that’s a recession. But there are these periods that occur within recessions where growth is trending up and down.

This 12-18 month trend in growth is what we call the growth rate cycle.

When growth is trending higher, that’s a cyclical upturn or a growth rate cycle upturn. When growth is falling or declining, that’s a growth rate cycle downturn or an economic cycle downturn.

This growth rate cycle is responsible for over 90% of all gains in the stock market over the last 25 years. 

The chart below shows the growth rate of the coincident index, the same chart as above but zoomed in on the last economic expansion to highlight the growth rate cycle. 

From 2012 through 2019, there was no recession, the growth rate never went below 0% for a sustained period of time, but we had several distinct growth rate cycles.

Growth fell to 0%, rose to nearly 4%, fell below 1%, and rose back near 4%.

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These are not monthly or even quarterly moves. The noise and month-to-month chop are not informative and are unpredictable. Anything shorter than five months is not a sustained economic cycle trend.  

The 6-18 month trend in growth, defined by coincident indicators, is the most important trend in investing.

The four indicators that make up the overall coincident index, don’t always move exactly together.

Generally, the trends align, but the peaks and troughs can vary by several months.

Also, the volatility of each indicator is much different. Industrial production growth, graphed in light blue in the chart below, is far more volatile than employment growth, which is graphed in red.

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The individual cycles are important to monitor, but if we take the aggregate of all four, we get a very solid read on the economy.

The composite of all four indicators, the coincident index from the charts above, is graphed with the thick black line.

We want to separate or focus on the 6-18 month cycles in growth.

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Over the last 25+ years, the performance of all major assets is radically different during the cyclical upturns in growth and the cyclical downturns in growth.

The 6-18 month trending direction in economic growth is the most important fundamental factor impacting asset markets. 

Asset Class Performance During Growth Cycles

Going back to 1996, over the last 25 years, we can break the world into these two phases, growth rate cycle upturns and growth rate cycle downturns.

We don’t have to worry about recessions because all recessions happen during downturns. 

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Interestingly, the average growth rate cycle upturn lasted 1.1 years while the average downturn lasted 1.6 years.

If we look at the average annualized performance for the S&P 500 or ETF SPY, we see a major difference in performance based on the trending direction in economic growth.

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During economic cycle upturns, the average annualized return for the S&P 500 was almost 20% while it was just 4% during downturns.

The average annualized return for the S&P 500 was 5 times as large during upturns compared to downturns.

Stocks have average historical volatility of around 16%. For 20% annualized returns,16% volatility is reasonable. But 16% volatility for just 4% returns is a terrible risk-adjusted return.

The following chart really shows the power of the growth rate cycle.

The green line shows what happens if you bought and sold the S&P 500 at the start and end of each growth rate cycle upturn. So when the economy was in an upturn, you held the S&P, and when the economy was in a downturn, you held nothing or just a money market.

The red line shows the opposite. The red line shows what happens if you bought the S&P 500 only during downturns and if you held nothing during upturns.

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The S&P 500 has a total return of nearly 775% during upturns and a total return of just 25% during downturns since 1996.

Roughly half the time over the last 25 years was spent in a downturn but almost none of the gains occurred in those periods.

The S&P 500 made virtually 100% of the overall gains during a fraction of the time. Only when the trend in growth was sustainably rising.

The chart below shows buying and holding the S&P 500 since 1996 or buying the S&P 500 during upturns and holding just a money market fund during downturns, like the last chart.

The buy and hold strategy does still win in total return terms. 

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The economic cycle portfolio had a compounded return of 9.2% vs. 9.8% for the buy and hold. So six-tenths of a percent less compounded return over the last 25 years but a max drawdown of 25% compared to 51%, and average volatility of 9% vs. 15%.

So you give up six-tenths of a percent in return for basically half the volatility and drawdown risk.

You kept 94% of the return but got rid of half the volatility or half the risk.

We’re still just holding a money market fund during downturns, and you can already see how the growth rate cycle is responsible for over 90% of the market returns and how you can enhance your returns while eliminating or reducing your drawdown risk massively.

If we do the same exercise with long-duration Treasury bonds, as you might expect, the return is better during economic cycle downturns.

Long-term bonds rose almost 9% annualized during downturns on average.

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So what we know is that the S&P 500 has all its gains during upturns, and weak performance during downturns, and bonds have strong performance during downturns and weaker performance during upturns.

So instead of a money market, what if we held 100% stocks during cyclical upturns and switched and held 100% long-term bonds during downturns.

To be perfectly clear, this is an extreme example and used just to demonstrate the power of the growth rate cycle.

I am not suggesting you can perfectly time every pivot for the last 25 years, but the results in the chart below should make it clear that pivoting with the growth rate cycle is absolutely the target or absolutely what you should try and do if you’re looking to maximize returns while reducing risk and volatility.

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So the direction of coincident economic growth over 6-18 month periods or the "growth rate cycle" is absolutely critical for asset allocation and investment performance.

Spotting Inflection Points

Coincident economic growth, as the name suggests, coincides with peaks and troughs in the economy but it doesn’t tell us where we are going.

Understanding the current direction of growth is a leg up on 90% of investors, but we do need to know where economic growth is heading to make the most timely shifts in asset allocation.

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We are able to consistently spot inflection points in coincident economic growth over 6-18 month windows by using a combination of secular economic trends, monetary and fiscal policy analysis, and leading economic indicators. 

Each of these topics requires separate discussion and analysis. 

On, there are other articles and videos that discuss secular economic trends and monetary/fiscal policy in detail. Here are two to check out.  

Fiscal Policy Analysis: Fiscal Stimulus: The Economy's Third Strike

Video on the Growth Rate Cycle: The Importance of Growth Cycles (Video)

I have a monthly report that goes out in the second week of each month covering the leading indicators of the economic cycle.

I also have a quarterly video presentation that updates this entire growth rate cycle process and provides an outlook for asset class performance.

You can learn more about those reports by clicking here. 

Staying focused on the growth rate cycle or the direction of economic growth will have the most significant positive impact on your investment strategy. 


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