Historically, mid-cycle slowdowns have overlapped with equity upswings, and have set the stage for a rotation from cyclicals to traditional growth.
Many view economic slowdowns as a signal of an impending retreat in equities. However, this overly simple view is not supported by historical data. In fact, past mid-cycle slowdowns have overlapped with equity rallies. Of course, the market may not always follow the same pattern every economic cycle, but history does provide a valuable context for evaluating the risks and opportunities of the current environment.
Consider the slowdowns experienced in the market in 1965, 1985 and 1986, and 1995. Each of these slowdowns was preceded by Fed rate hikes that appeared to be early or directed at some excess building in the real economy or financial markets. In each case, the market reacted to the slowdown before the GDP reflected it—in other words, the market was a leading indicator.
In 1984, the Fed was raising rates and the S&P 500 Index began the year at 169. By mid-July, the index bottomed at 148 (a 12.4% correction), and then rallied to end the year at 166 for a -1.77% price return. Once the slowdown showed up in the GDP figures in 1985-1986, the market rallied in anticipation of a slowdown and more controlled growth. From January 1, 1985, to December 31, 1986, the market rallied from 166 to 247, a nearly 50% rise. By August of 1987, the index was at 328, representing a price rise of nearly 100% from when the Fed stopped raising rates. Half of the market move occurred during the mid-cycle slowdown.
Once again, in the 1990s bull market, the economy experienced a mid-cycle slowdown; and again, the slowdown was preceded by the Fed raising rates in 1994 with a GDP slowdown occurring in 1995. The market came into 1994 at 464 and closed the year at about 460 for virtually no price return. But during this same year that economic slowdown occurred and the Fed rate hikes stopped, the market began a huge sustained bull market that peaked at 1525 in March 2000—a 229% move.
Market Performance and GDP Growth
As the charts show, the market was a leading indicator of mid-cycle slowdown in the late 1960s, the 1980s and 1990s. Then, while GDP was reflecting mid-cycle slowdown, the market was advancing.
| Changes in GDP Growth and the S&P 500 Index |
| March 31, 1965 - December 31, 1969 |
 |
| March 31, 1983 - December 31, 1987 |
 |
| March 31, 1993 - December 31, 1997 |
Source: Bloomberg, LP. The S&P 500 Index is an unmanaged index generally considered representative of the U.S. stock market. Unmanaged index returns assume reinvestment of any and all distributions and, unlike fund returns, do not reflect fees, expenses or sales charges. Investors cannot invest directly in an index. |
Leadership Shifts in Mid-Cycle Slowdowns
One of the significant changes that occurred in past mid-cycle slowdowns was a shift from a pro-cyclical market to a more growth-oriented market. In each, the value and cyclical stocks that led during the early phase of the bull market were replaced by more traditional and stable growth stocks in the next phase.
At a certain point in every economic cycle, top-line growth, pricing power and high utilization rates create a perfect storm, spurring eye-popping earnings growth rates for cyclicals. During these periods, earnings growth rates of more than 100% are not uncommon. But, the same forces that brought about the very high growth rates also shift and bring about dramatic negative swings in the earnings growth of cyclicals. Meanwhile, the more stable growth companies continue generating more of the same, steadier earnings growth.
Conclusion
We believe mid-cycle slowdowns—such as the current economic climate—can bring opportunities for long-term, forward-looking investors. In keeping with our analysis, our strategies currently favor high-quality, large-cap traditional growth companies with prospects for sustainable earnings growth. In recent years, many of these companies have seen significant expansion in their enterprise values, but their stock prices have moved sideways. As the mid-cycle slowdown unfolds, we expect the market participants will rotate away from momentum-driven cyclicals, and return to companies with steadier earnings growth prospects.