The S&P 500’s 32.4 percent gain in 2013 was the benchmark’s best showing since 1997, the height of the 1990s economic boom and tech bubble.
But there’s a difference between 1997 and 2013: Despite the strong return posted by equities last year, valuations remain far more reasonable than 16 years ago.
At the end of 1997, the S&P 500 traded at 22.3 times trailing earnings and 3.9 times book value, compared to 17.2 times earnings and 2.6 times book value today.
Moreover, the US economy is in the early innings of a classic mid-cycle recovery, a phenomenon that historically has been a strong driver for stocks–especially cyclical sectors such as industrials, information technology and financials.
Past as Precedent: Three Mid-Cycle Recoveries
Mid-Cycle Slowdown and Recovery No. 1: 1987 to 1994
According to the National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee, the US endured one of its mildest postwar recessions Between July 1990 and March 1991.
Though shallow by any historical yardstick, this economic downturn shows up prominently in the Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) for the manufacturing sector, one of my favorite quick-and-dirty indicators of the US economy’s health.
PMI readings greater than 50 indicate an expansion in economic activity, while values below this threshold correspond with a contraction. A decline to 45 or 46 signals a heightened risk of recession.
In the business cycle of the late 1980s and early 1990s, PMI slipped to 46 in July 1989–one year before the recession officially started. After US gross domestic product shrank for two consecutive quarters, the economy returned to growth in the second quarter of 1991. This momentum continued through late 1994.
Mid-Cycle Slowdown and Recovery No. 2: 1994 to 1997
Although the US economy grew at a 4 percent rate in 1994, US markets endured a tough run, with the S&P 500 rising 1.4 percent on the year.
The main culprit: Fearing an overheating economy and inflationary pressures, the Federal Reserve doubled the Fed funds rate to 6 percent in mid-1995 from 3 percent at the end of 1993.
Meanwhile, manufacturing PMI deteriorated to less than 46 in early 1996 from more than 59 in late 1994, a level that indicated an elevated risk of recession.
But the US economy didn’t slip into recession in the mid-1990s. After US GDP growth slipped to less than 2 percent in 1995, economic activity accelerated, fueled by the Fed’s decision to cut rates in September and December 1995.
Because the US economy didn’t suffer an outright recession until 2001, 1994 to 1997 is another textbook example of a mid-cycle slowdown and recovery.
That is, the stock market treaded water in 1994 in anticipation of a slowdown caused by tightening monetary policy. But the economy emerged from this soft patch, and S&P 500 put together three of its best back-to-back years in decades, rising 37.5 percent in 1995, 22.6 percent in 1996 and 33.1 percent in 1997.
Even investors who waited until 1996 to add equity exposure were rewarded with solid gains.
Mid-Cycle Slowdown and Recovery No. 3: 2002 to 2006
Between 2002 and 2006, the US experienced another mid-cycle recovery that came on the heels of a mild economic downturn between March and November 2001.
Although the US economy started to recover in 2002, the S&P 500 generated weak returns from 2001 to early 2004, as the market floundered in the aftermath of a speculative bubble in tech stocks that ended abruptly in 2000.
Despite a vicious bear market that started in March 2000 and a significant selloff in the wake of the Sept. 11 terror attacks, the S&P 500 still traded at 26.75 times trailing earnings and 21.7 times forward earnings estimates as of the end of 2001.
To worsen matters, the US economy appeared to falter in mid-2002, with PMI slumping from a high of 54 in mid-2002 to a low reading of 46.1 in April 2003.
US economic growth slipped from 3.8 percent in the first quarter of 2002 to an annualized rate of 0.2 percent in the final quarter of the year.
At the time, many pundits forecast that a recession would take hold–and plunging stock prices gave credence to that view.
But PMI and US economic growth surprised to the upside in early 2003, with PMI climbing above 50 by July 2003. In the 12 months after PMI bottomed in April 2003, the S&P 500 surged by 22.9 percent.
The uptrend in stock prices that followed these mid-cycle slowdowns resembles a post-recession recovery. This pattern makes sense: Mid-cycle slowdowns are, in effect, a mild recession where economic trends don’t deteriorate to levels to qualify as an outright contraction based on the NBER’s official definition.
Check out this graph tracking the average performance of the S&P 500 and the S&P Small-Cap 600 Index in the 12 and 24 months after the past five recessions and the economic slowdowns ended May 1985, January 1996 and April 2003.
Source: Bloomberg, Capitalist Times
On average, the S&P 500 jumped 17.1 percent in the first 12 months after each cycle and a total of more than 35 percent after another 12 months.
Smaller companies tend to have less-diversified geographic footprints and product mixes than their large-cap peers, increasing their sensitivity to industry and economic conditions.
And the S&P Small-Cap 600 Index exhibits a beta of almost 1.1, indicating that these stocks tend to move faster than the S&P 500 on the upside and the downside.
Accordingly, small-cap stocks traditionally have outperformed when equities rally and underperform during periods of weakness; the S&P Small-Cap 600 Index rallied an average of 22.6 percent in the 12 months after each down-cycle and a total of 44.2 percent after another 12 months.
This history underpins our decision to beef up the Wealth Builders Portfolio’s exposure to small-capitalization names, including a play on an industry that’s finally emerging from a period of excess capacity.
With a market capitalization of less than $900 million, our favorite trucking outfit has moved aggressively to cut costs and remove operational redundancies.
In addition to these company-specific initiatives, the industry as a whole has eliminated much of the excess capacity that has plagued the group since the Great Recession. The operators that survived this consolidation have regained pricing power for the first time in years.
Against this backdrop, the small wonder that we added to our Wealth Builders Portfolio could see upside of 50 percent from the stock’s current quote.
Historical precedent also supports owning stocks from cyclical industries in the early stages of an economic acceleration.
In the first 12 months after manufacturing PMI bottomed in each of the past five cycles, economy-sensitive sectors (financials, industrials and materials) and security classes (small-cap stocks) outperformed the S&P 500.
This outperformance historically has continued for the next 12 months, with cyclical sectors such as energy, industrials, financials and materials generating superior returns the S&P 500 and defensive sectors such as health care lagging the index.
Of course, data constraints restricted our study to the past five economic cycles, a relatively small sample size.
And although top-down analysis is important, this approach isn’t the final word; successful investors wed sector-level trends with solid stock selection to identify the top performers in advantaged and disadvantaged industries.
Applying Our History Lesson to the Present
We expect equities to follow the same basic pattern as the past seven economic cycles.
Once again, we turn to the ISM’s PMI for the manufacturing sector to illustrate the recent economic cycle.
After an initial recovery following the 2007-09 Great Recession, PMI peaked in early 2011 and gradually fell to a low of 49 in May 2013. This slide stemmed from a litany of perceived crises–flare-ups of fear surrounding Europe’s sovereign-debt crisis, two battles over raising the US debt ceiling and a series of US tax hikes and cuts to government spending.
But PMI has resurged since May 2013, suggesting that the US economy has emerged from this mid-cycle slowdown.
The S&P 500 has gained about 15 percent over this period; however, if history is any guide, US equities should deliver double-digit gains in 2014, with small-cap names and cyclical fare leading the way.
Our Wealth Builders Portfolio is well-positioned to take advantage of these trends
Source: Bloomberg, Capitalist Times Premium
Since the model portfolio’s inception on June 20, 2013, our average recommendation has returned 16.1 percent, compared to the S&P 500’s average gain of 11.8 percent over an equivalent holding period.
Recent Media Appearances
01/06/14: BNN — Roger Conrad, Top Canadian Energy Stock Picks
Free Live Webinar
Profiting from the US Energy and Manufacturing Renaissance
4:30 p.m. – 5:30 p.m. Wednesday, Jan. 15, 2014
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“America’s Energy Renaissance: Top Plays for Income and Growth”
9:00 a.m. – Jan. 18, 2014
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Arlington, VA 22204
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Cost: $28 online registration until 01/14/14; $33 late registration, 01/15/14 – 01/17/14; $38 at the door (space permitting)
The World MoneyShow Orlando
Jan. 29 – Feb. 1, 2014
Gaylord Palms Resort & Convention Center
6000 West Osceola Parkway
Kissimmee, FL 34746
Jan. 30, 1:00 pm – 3:00 pm: Toward US Energy Liberty Day
Feb. 1, 8:00 am – 8:30 am: Beating the Big Money to the Best Dividend-Paying Stocks
Jan. 30, 1:00 pm – 3:00 pm: Toward US Energy Liberty Day
Jan. 30, 5:15 pm – 6:15 pm: Under-the-Radar Energy Plays for Growth and Income