What really drives earnings and prices?
The business or economic cycle is generally considered to have four stages: expansion, peak, contraction, and trough. Equity earnings and prices are both driven by this cycle and the sentiment that accompanies it. This generally affects growth and value investments about equally, as shown in Figure 1. Both the S&P 500® Growth Index and S&P 500® Value Index have tracked the Purchasing Managers’ Index (PMI) closely since 1999. For this reason, growth/value may not be the best framework for understanding the earnings outlook. Looking through the lens of cyclical sectors vs. defensive sectors may offer more insight.
Figure 1 – Earnings and prices are driven by the business cycle and sentiment
|Earnings Sensitivity: Growth & Value vs PMI
||Price to Earnings: Growth & Value vs PMI
Source: Natixis Investment Managers Solutions, FactSet. Growth measured by S&P 500 Growth Index; Value measured by S&P 500 Value Index. Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.Early vs. late cycle sectors and industries
Specific sectors tend to respond differently to the various phases of the business cycle. Early on – during the expansion leading to a peak – energy, financial and industrial sectors tend to outperform. These industries are highly levered to the rate of change in economic growth and do well during periods of growth acceleration. Later in the cycle, as growth slows and approaches a trough, consumer staples and healthcare tend to dominate. Other sectors, such as technology, are generally less sensitive to cyclicality. The cyclical sectors follow the business cycle very closely while the defensive sectors do not. Therefore, it is more important to understand your portfolio’s exposure to the business cycle than its exposure to growth and value style factors.
Use case: portfolio positioning and manager selection
Unlike a style approach, which doesn’t account for economic cyclicality, we are suggesting a framework to measure a portfolio’s exposure to the business cycle. To do this, we created two baskets of ten equally weighted industries which we use as a baseline to measure the sensitivity of any portfolio, mutual fund, ETF or individual security to these early and late-stage cycle dynamics. We measure that exposure by calculating the beta of a model portfolio’s equity sleeve’s excess return to these two baskets.
When assessing managers or ETFs using a traditional value/growth perspective, it is critical to recognize that there is a very wide dispersion of value manager styles. For example, some value managers tend to own a lot of early-cycle companies, while other value managers tend to invest in more defensive or late-cycle sectors and industries. Conversely, growth managers tend to own more secular companies and industries that have a narrow range of cycle betas. Said differently, growth managers tend to outperform cyclical sectors and industries later in the cycle. In fact, they tend to behave more like defensive sectors, as shown in Figure 2.
Figure 2 – Wide dispersion with value managers compared to growth managers
Source: Natixis Investment Managers Solutions, Morningstar, FactSet. Beta measures a security’s volatility in relation to a benchmark where the benchmark equals one. A beta greater than one indicates that it is riskier than the benchmark. Beta only considers risk in relation to the benchmark and does not account for risk specific to the security. Excess return is the percentage of return over the return of the relative benchmark.Refining portfolio construction
There are many ways to analyze portfolio holdings, but considering performance in the context of the business cycle may offer new levels of insight. To learn more about the portfolio analysis capabilities provided by Natixis Investment Managers Solutions, contact us for a comprehensive portfolio evaluation.
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Morningstar rankings for the the Large Cap Value and Large Cap Growth categories are as of May 1, 2019 – May 21, 2021. The total return percentile rank for the specified time period is relative to all funds that have the same Morningstar category. The highest (or most favorable) percentile rank is 1, and the lowest (or least favorable) percentile rank is 100. Rankings are subject to change monthly. Morningstar rankings do not include the effect of sales charges.
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