Business Cycle Investing: Low Risk High Payoff

In a recent work, I wrote that “Time In The Market” is total bullshit: a fairy tale paradigm designed by those seeking to absolve themselves of the pain and guilt of having made crappy investment decisions. I stand by that statement because to a huge extent, risk management comes down to the comparatively simple concept of business cycle investing. There is a huge distinction in my mind between the strategic, multi-year decade-to-decade positioning that someone engaging in business cycle investing might undertake compared to explicit ‘market timers,’ who, for the most part, engage in pseudo-intellectual nonsensical analysis to try to day trade the market. At its core, my philosophy of business cycle investing is simple: I want to buy when recessions are underway and get the hell out before the next recession hits.

The Importance Of Business Cycle Investing & Recessions In Equity Returns

It’s been so long now since we’ve had one that most people, particularly younger millennials, have zero frame of reference for just how absolutely shitty recessions are. All of the annoying corporate ‘goodbye we’ll miss you!’ parties that happen when people leave now? Those get replaced by sullen lines of zombies carrying cardboard boxes marching out the door while their colleagues awkwardly look on, knowing the first package during the recession is always the best. Its sheer terror when you realize you thought you could handle volatility, but a 60% equity drawdown blasting a hole in your nest egg while you watch all of the moving vans from the foreclosures is JUSSSSST a bit more than you signed up for.

But I digress. The official self-appointed “Recession Monitors” for the United States is the National Bureau of Economic Research (NBER) who have logged every recession in American history. For business cycle investing, recessions are the reset buttons where equity valuations get crushed and performance is terrible. They are the device by which valuation predicts longterm return and sanity restored to equity markets.

Note that the NBER only calls recessions retroactively. In fact, we were a full year into the Great Financial Crisis before the NBER was able to clearly identify a recession had begun. The advantage are there are absolutely NO false positive with this, however, it means a recession is not observable in real time:

beginning and end dates of recessions

Going back to 1976 (about the first time the NBER started issuing official peak/trough calls for economic activity) for the S&P 500 shows a couple of interesting things. First, we divide months into

  • Whether or not a recession is currently under way.
  • Whether or not the month in question occurred within the first 72 months after the NBER declared a recession.

The annualized rate of return for each of these buckets is startling:

business cycle investing

The interpretation of this chart is that the average return for the 360 months (5 recessions x 72 months) immediately following a NBER recession announcement is dramatically higher than all of the rest of the months, to the tune of nearly 10% per year! Ride the upside, protect principal during the later stages of the expansion, dodge the massive underwear soiling downturns. The crux of business cycle investing.

Business Cycle Investing

If it was as easy as “Hey, on June 9th 2021 a recession will begin! Sell your stock before then,” then obviously everyone would follow suit. Unfortunately, a recession is not observable in real time, and in my opinion is itself a dynamic event which cannot be predicted. History is of some guide, with the average time between trough-to-trough in the business cycle averaging approximately 6 years since the late 1970s:

time between recessions

My own philosophy towards investing in one in which we can tell the state of the economy by the shape of the yield curve, nevertheless a simply backtest based on the historical data is insightful. What happens if you engage in business cycle investing according to the following plan? What if we use this ‘6 year rule’ to guide strategic investing through the business cycle? We’d do the following:

  • Buy stocks (S&P 500) on the date in which the NBER declares a recession is underway (remember this is going to occur on average 6 months after the recession began)
  • Hold them for 6 years.
  • Sell them and switch immediately to a bond index.
  • Wait for next NBER recession

Business Cycle Investing: Performance

Easy enough plan, but how does business cycle investing perform? Before we open up the kimono to see the results, there is one VERY important thing to consider. There have been 5 NBER recession signals since 1976 but only 4 “Next Recessions.” The current business cycle is likely at a high point, meaning which anyone that bought the market in December 2008 and held it until now is obviously doing better than someone that sold out in December 2014. For a more thorough backtest, this analysis needs an update when the next recession rolls around. I’ll take a gander at what it looks like in the next section.

The fact we are measuring from the December 2008 low to a business cycle high rather than a post-cycle low means the current S&P 500 market value is an extremely favorable slant towards just buying and holding. Even despite this, business cycle investing yields superior performance for all entry dates prior to the lows of early 2009:

business cycle investing since 1976

business cycle investing since 2000

If it seems like magic, it really isn’t. It’s just ducking the 41% draw down in 2000-1 and 50%+ drawdown in 2007-8 in exchange for missing out on the late years of a bull market.

It’s fairly straightforward using some of the fanciness of data tables within Excel to calculate the internal rate of return for both strategies based on any given start month. The difference in the two yields the performance premium of business cycle investing relative to ‘buy and hold’. Furthermore, it’s equally easy to calculate the reduction in the standard deviation of the returns. Lower standard deviation means lower volatility in portfolio value:

business cycle investing vs buy and hold

Business Cycle Investing: The Next Recession

The above chart is saying:

  • If at any point in the 32 years prior to October 2008 you engaged in a strategy by which you would just own the 6 years immediately following a recession and sit on the sidelines the rest of the time, that strategy is currently better off than buying and holding from THE EXACT SAME POINT IN TIME.
  • Said one more way, starting this strategy IN ANY MONTH between January 1976 and October 2008 results in better returns than ‘buying and holding’.
  • There is far less variability from business cycle investing than through pure buying and holding.
  • This strategy is currently underperforming since 2008
  • However, in a college class, this would receive a grade of ‘incomplete’ because it is being judged from a recession trough (January 2009) to a market peak (October 2018) and not the next recession trough (maybe 2020?)
  • I believe after the current business cycle is complete, business cycle investing will outperform.

I do not claim to know when the next recession will come, but I feel strongly that it is likely to be characterized by the same type of equity drawdown which characterizes past recessions: somewhere in the realm of a 30-50% reduction in equity values.

Lest you think I’m being overdramatic and fear-mongering, in 2000 the S&P 500 lost about 45% of its value, and in 2007 about 51% even after accounting for dividends. A 30% correction, based on current equity valuations seems a rather pedestrian prediction. As a result, the longterm performance of business cycle investing again trends positive in all periods:

business cycle investing the next recession


My investment philosophy is one in which individuals can leverage their greatest asset to generate quality returns with less risk: time. Simply by being patient and waiting for a homerun pitch as clearly and unequivocally announced by the National Bureau of Economic Research, it is possible through business cycle investing to generate positive value with far less of the downside. I’d ask investors to question: what is the upside from the current market, and what do you believe?

This article is for informational purposes only and is not investment advice, nor is it a recommendation to buy or sell securities. Consult with an investment adviser for any actionable advice. 

1 Response

  1. Ckarion says:

    I like the extremely clear buy and sell signals, as they remove all guesswork and emotion from the process.

    The problem I forsee is that one would have to have nerves of steel to dump a large nest egg into the stock market when the economy is poor and the financial system looks fragile and everyone is terrified (I’m assuming the delay between the onset of recession and the anouncement of it will not be long enough for things to have calmed down). Cudos to those who manage it!

Leave a Reply

Your email address will not be published. Required fields are marked *