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Timing the Economy is Impossible

But Economic Downturns Often Spell Opportunity

Deep-Dive

Intro

When you think about investing, it's easy to focus on picking the "right" stocks or timing the market perfectly, but there’s a bigger picture at play that savvy investors need to consider—the economic cycle. 

This cycle is the rhythm of expansion and contraction that economies experience over time, and it plays a huge role in shaping investment outcomes – especially as it applies to the short-term.

In this write-up, we’re diving into the relationship between economic cycles and investments, focusing on how different asset classes behave in various phases, along with our view on how to best navigate these economic cycles.

Our aim? To equip you with strategies to weather economic downturns and position yourself to capture gains when the economy rebounds.

Why Economic Cycles Matter to Investors

At the heart of every investment journey is the economic cycle, which comprises four main phases: expansion, peak, contraction, and trough.

Understanding where the economy stands at any given time can help you fine-tune your portfolio for maximum returns while managing risk. Let's break it down.

• Expansion: The economy is growing, with rising production, employment, and demand. Interest rates are generally low, which fuels spending and investment.

• Peak: This is the high point of the cycle, where the economy hits maximum output. Inflation is often high, leading central banks to raise interest rates, and the growth of both companies and the stock market starts to slow.

• Contraction: Economic activity slows down. Demand for goods and services decreases, unemployment rises, and stock markets typically decline. During this phase, many investors tend to retreat to “safer" assets like bonds.

• Trough: This is the low point in the cycle. The economy has bottomed out, and after a period of low or negative growth, it begins to recover, signaling the start of a new expansion phase.

These phases don’t just affect GDP numbers or unemployment rates—they also have a profound impact on financial markets. Understanding these shifts allows investors to make smarter choices about how to allocate capital across asset classes during different stages of the cycle.

Let’s dig in to how an understanding of economic cycles can provide knowhow in managing risk and recognizing potential opportunity…

Equities Shine During Expansion

Equities, or stocks, are often the “go-to” asset for investors during periods of economic expansion. As companies generate higher revenues and profits, their stock prices tend to rise, and this draws more and more attention from potential investors.

If you have a long-term view, this phase is where equity-heavy portfolios can really pay off if you already have positions in companies with rising share prices. This is where you’ll see increases in the value of your investments on paper, as stock prices and the Market as a whole is on an upswing. However, assuming a new position during this phase is risky, since share prices are rising and there’s greater likelihood of overpaying for stocks.

Historical data backs this up. During non-recessionary periods, global equities have delivered substantial returns. For instance, U.S. equities, as tracked by the MSCI USA Index, have shown consistent growth during expansion phases, offering investors a chance to capitalize on economic booms. However, the key is knowing that stock markets can be volatile, and the peaks of the economic cycle often signal the end of big gains.

Let’s take for example Wayfair, an e-commerce giant specializing in home furnishings. It experienced significant growth during the post-COVID expansion (see graph below) as consumers increasingly invested in home improvements. Its stock surged, driven by the boom in online shopping and demand for furniture during lockdowns, making it one of the top performers in the Russell 1000 index.

If you had a position in Wayfair prior to this boom, you benefited greatly by the increase in its stock price. However, during the boom itself is clearly not when someone should have taken a position, as is evidenced by the subsequent decline starting in 2022.

Bonds - the “go-to” During Recessions

When the economy contracts, bonds generally outperform equities. Why? It comes down to what we call a "flight to safety." During recessions, investors seek refuge in less risky, more stable investments, such as government bonds. These assets, particularly high-quality fixed-income securities like U.S. Treasuries, tend to hold their value better than stocks when markets are in turmoil.

Looking at past recessions, bonds consistently delivered positive returns while equities struggled. For instance, during the COVID-19 crisis in 2020, U.S. Treasury bonds outperformed equities, offering a much-needed buffer for portfolios. This dynamic plays out repeatedly in history, reinforcing the importance of having bonds in your portfolio, especially when a recession is looming.

Now, analyzing the 10-year U.S. Treasury yield chart from 2014 to 2024 shown below, the pattern of a "flight to safety" is clearly visible. In early 2020, as the pandemic triggered a global economic shock, yields dropped significantly due to high demand for safer assets like government bonds.

You can see that bond yields plummeted as investors rushed to buy Treasuries, causing prices to rise and yields to fall sharply. However, from 2022 onwards, the yield starts to climb rapidly, coinciding with the economic recovery and rising inflationary pressures as central banks, like the U.S. Federal Reserve, began tightening monetary policy by raising interest rates to curb inflation.

This reinforces the idea that bonds can act as a haven during economic downturns but that market timing is notoriously difficult. Moving entirely into bonds during recessions might miss the eventual rebound in equities, as seen in the post-COVID recovery.

Timing the Market is Tricky

The problem with trying to time the market—by switching out of equities and into bonds, for example—is that stock markets often begin to recover before a recession officially ends. In fact, in each of the seven U.S. recessions between 1973 and 2021, the S&P 500 index started its recovery before the economy hit bottom. For long-term investors, this means that abandoning equities entirely during a downturn could cause you to miss out on early market gains.

Consider the 2020 recession triggered by the COVID-19 pandemic. Stock markets began rebounding just two months into the downturn, well before the economy had fully stabilized. The lesson here? Timing the market is more art than science, and staying the course often leads to better results.

Take Warren Buffett’s example. He’s clearly stated that “timing the economy is impossible,” and he doesn’t even listen to economists. But while timing the economy is an exercise in futility, as a whole, you can seek to exploit opportunity in stocks (or equities) during economic recessions and market downturns. Rather than running for the fences by selling off your stocks and trying to jump into “safer” assets like bonds, seek out new positions or double-down on existing positions in stocks that still hold strong long-term value. Such companies have long-term durable competitive advantages and an uncanny ability to spin off large amounts of cash.

Diversification: Your Best Bet for Long-Term Success

Building an all-weather portfolio is about more than just picking the right asset class for the right phase of the cycle. Although investment gurus like Buffett tend to focus their investments on a select few, for the average investor, the best strategy is broad market diversification. By spreading your investments across global equities, bonds, and other asset classes, you can reduce your overall risk while positioning yourself to capture gains during different phases of the cycle.

A well-diversified portfolio might include allocations to both developed and emerging markets, government and corporate bonds, and even real assets like property or commodities. This way, you're not putting all your eggs in one basket—and you're more likely to see steady returns over the long haul, regardless of where the economy is headed.

In 2022, for example, while many equity markets struggled, UK equities outperformed in GBP terms, highlighting how diversification across regions and sectors can help mitigate losses when some parts of the market underperform.

But be careful not to overdiversify! Read more about optimal diversification and the benefits of diversifying to an extent. 

Managing Risk in a Cyclical Market

One of the key takeaways from understanding economic cycles is how they help with risk management. During times of expansion, investors are often more willing to take on risk, chasing higher returns in the stock market. However, during periods of contraction, the focus shifts to preserving capital and reducing exposure to volatile assets.

Don’t follow the crowd…

A smart way to manage risk throughout the cycle is by going against the grain. For instance, during expansions, you might enjoy the paper gains of existing positions while finding new opportunities may be limited. But as contraction looms, be sure you’re in a good position to take advantage of value-plays, companies with strong fundamentals and long-term outlooks that you can pick up at a discount.

“Be fearful when others are greedy, and be greedy when others are fearful.”

-Warren Buffett

Patience Pays Off

Economic cycles are, by their nature, cyclical. That means the downturns, as painful as they may be, are always followed by recoveries. The key to long-term investing success is not just reacting to the highs and lows of the market, but staying the course and keeping your eye on the bigger picture.

For example, historical data shows that, on average, global equities returned +27% in the six months following the end of a recession. This underscores the importance of being patient and maintaining a strategic perspective, even during tough times.

Stay Strategic, Stay Diversified

Investing is a long game, and the economic cycle is one of the most important factors to consider. By understanding how different asset classes perform during various phases of the cycle, you can construct a portfolio that not only weathers downturns but also positions you to capture growth during expansions.

Diversification, patience, and a well-timed strategy are your best tools for navigating the ups and downs of the market. With these in hand, you’ll be better equipped to make informed decisions and achieve long-term financial success, regardless of where we are in the economic cycle.

Key Insight

Timing the economy is near impossible. Instead, the best approach is to stay the course for the long-term if your investment positions still present solid long-term value.

Instead of running for the fences by selling off stocks with declining prices or jumping into bonds, seek to exploit opportunity in stocks (or equities) during economic recessions and market downturns.

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.

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