I Hate Economic Forecasts and Stock Sector Analyses, But ...

By Tom Madell

While for the entire year thus far, the average US stock fund or ETF is showing small positive returns, if one looks at how most funds have done since late January, we see that generally there have been no gains, and even losses.

Ten months is a long period for stocks to have been stalled, especially considering how they did during the prior 5 years from 2013 through 2017. For example, looking at three major domestic stock index funds, we can see this visually:

Since these 3 index funds are usually outperformers compared to most diversified Large, Small, and Mid-Cap funds, we can see that on the whole, it's been a volatile 10 months with little overall gains.

Things could still change during the remainder of this year, but only once over the last 5 years, in 2015, did we see flat to slightly negative returns. But the remaining 4 years generally showed double digit returns. As it now appears, those 5 years were still relatively early in our now long economic expansion.

Now, however, I, along with prominent economists, are starting to see some evidence that the current economic cycle is in its latter stages. But the evidence thus far is somewhat mixed.

You might be asking what difference does it make to a fund investor where we are in this cycle? It turns out it could be quite a bit.

It is always tricky to determine exactly the boundary line between the middle and late stage of an expansion, although the fact that we are now well into the 9th year of an economic recovery since June 2009, one of the longest ever, might alone suggest we are in the latter.

But here are some more specific indicators of an approaching end-of-the-cycle, along with my impressions of where we stand on each indicator: (Readers who want somewhat more technical information on stages of an economic cycle and their investing implications can review this article from Fidelity Investments.)

• A build-up of inflation. While still considered relatively low, inflation has been creeping up over the last several years

• A possible slowdown in economic growth as measured by gross domestic product (GDP). The latest reading of 3.5% is below the previous quarter's 4.2%; further, most economists are now predicting significantly lower GDP next year.

• A potentially overheating economy. Economic data has been running generally at the upper range of what is historically expected, such as an extremely low unemployment rate.

• Tightening monetary policy and credit availability. The Fed has been on a several year campaign now to raise rates and is expected to continue to so; also, credit card and mortgage loan availability do appear to have become somewhat more restrictive.

• Slowing corporate profit margins. This indicator does not appear to be happening yet, although a sharp drop-off is predicted by many beginning next year.

• Finally, inventories tend to build as sales growth declines. This may have begun in certain areas of the economy, such as autos and retail goods.

Unfortunately, since such data is usually reported with a lag of up to several months, it's hard to know in real time, the exact state of the economy at any exact moment. Furtherer, observed data can readily reverse from quarter to quarter. So the best one can do is to look for signs that these significant economic cycle indicators may be starting to happen and are continuing over more than a few months.

You may not be aware (or even care) which sectors of the economy your funds are most heavily invested in, but as I will point out below, knowledge of how these sectors tend to perform over the course of an economic cycle (which runs from right after a recession ends (early cycle), to mid-cycle, to near the end of the cycle, and finally, into a recession) can potentially help your longer-term returns.

Historically, in the late stages of a typical cycle, which has in the past averaged about 1.5 years in length, one can expect the following sectors to do best, according to the article cited above:

Energy

Health Care

Materials (Natural Resources)

Secondarily, good sectors to be in would be

Consumer Staples (Consumer Defensive)

Utilities

On the other hand, Technology and Consumer Discretionary (Consumer Cyclical) have been performance laggards. These sectors have tended to do well earlier in the cycle.

The remaining 4 sectors, Real Estate, Financials, Industrials, and Communications, haven't shown a clear late-cycle pattern. (All except Communications have also tended to do well earlier in the cycle.) Therefore, if we are in the late stages of the current economic cycle, you may want to tilt your funds toward an emphasis on those that have above average doses of the above 5 mentioned sectors while maintaining a reduced emphasis on the two typically laggard sectors.

Interestingly, performance-wise, while Technology and Consumer Discretionary stocks have been the best places to be over the course of the entire current expansion, it appears that things have started to change over the last several months, possibly because we are entering the above historical pattern shown in the late-cycle period.

The following list shows how funds that focus on the above sectors have done over the past 3 months in order from best performers to worst. The letter in parentheses after each sector shows which late-cycle grouping the sector has been shown to perform in, in the past, from best (B), to in-between (M), to worst (W), as just outlined above:

1. Utilities (B)
2. Consumer Defensive (Consumer Staples) (B)
3. Real Estate (M)
4. Communications (M)
5. Health (B)
6. Industrials (M)
7. Financials (M)
8. Consumer Cyclical (Consumer Discretionary) (W)
9. Natural Resources (B)
10.Technology (W)
11. Energy (B)

So, if we look at how funds that focus on the above sectors have done over this 3 month period, we can see, while all 11 sectors have done negatively, except Utilities, the above historic patterns of late cycle performance may be starting to appear. That is, the best performing sectors have been Utilities and Consumer Staples while two of the worse performers have been Technology and Consumer Discretionary. However, contrary to the usual late-cycle pattern, Energy and Natural Resources have done quite badly. Energy stocks have fallen into a bear market, likely due to relatively recent U.S. shale production that is not part of the historical data included in the Fidelity research cited above.

Of course, you could try to tilt your portfolio to take advantage of these outperformances merely by selecting some sector funds in the presumably desirable sectors. For example, Vanguard offers sector ETFs in all of these 11 sectors. However, sector ETFs funds may not be for everyone as they are not diversified and may require a brokerage account. Instead, you might choose 1 or more sector mutual funds. For example, Vanguard currently has 4 such funds.

But even without sector-specific funds, you can take advantage of this knowledge to overweight diversified funds that are more heavily weighted toward the late cycle best performers, while underweight in the late cycle worst performers.

Within my October Model Stock Portfolio, you can find such funds with the help of the "Portfolio" tab when you type in the fund symbol on the Morningstar.com site. For example, when you go to the Performance tab of the Vanguard 500 Index fund, VFINX, you get to the following web page. If you now scroll down, you will see the fund's weightings in the above 11 sectors. (In this case, the fund has its largest weighting in Technology, so if anything, you might want to underweight this fund in your portfolio, if we are indeed in the latter part of the economic cycle.)

Which funds within my domestic Portfolio might you especially want to consider overweighting, perhaps even beyond the percentages shown in my Oct. '18 Model Portfolio? The following would be good choices, based on having at least 40% of their investments in presumalby favorable late cycle sectors:

-T. Rowe Price Dividend Growth Fund (PRDGX)
-Vanguard Equity-Income Fund (VEIPX)
-Vanguard Value Index Fund ETF Shares (VTV)
-T. Rowe Price Equity Income Fund (PRFDX)
-Vanguard Energy Fund (VGENX)

Remember that, as a general rule as I discussed in the Nov. Newsletter, Growth funds tend to have the majority of their investments in Technology and Consumer Discretionary sectors, while Value funds tend to favor Financials and Health Care. This suggests an overweighting of Value over Growth funds. In fact, over the last 6 months, an index fund measuring Large Cap Value stock performance, Vanguard Value Index (VIVAX), has outperformed the comparable fund for Large Cap Growth, Vanguard Growth Index (VIGRX) by over 6 percent.

Of course, there are no guarantees that overweighting typical economic cycle outperformers based on where we are in the cycle will do better than just a buy and hold strategy of diversified funds. If it were easy to predict which funds will outperform, it would therefore be easy to outperform the overall market. We know that that is certainly not the case.

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