Recession Aftermath

CFA Level II Portfolio Management
#1

Excerpt:

A macro topic for this week’s fixed-income committee is the possibility that the US Federal Reserve Board (Fed) will raise the federal funds rate (FFR) 25 bps at their next meeting. Quantum’s committee believes that the Fed is likely to hold off raising the FFR for at least six months because of weak economic data and that weakness will be seen in the upcoming payroll numbers. Quantum expects the monthly non-farm payroll report to show that the US labor market added only 90,000 jobs this month, roughly in line with consensus expectations. The committee is debating what will happen to the short end of the US yield curve (and what will happen subsequently to short-dated bond prices) if the payroll report comes in at the level they expect.

Quantum’s committee forecasts weaker than expected GDP growth in the future and expects that GDP growth will be more volatile as the economy ultimately adjusts to a changing interest rate policy. Rutherford believes these factors will exert downward pressure on short-term Treasury Inflation-Protected Securities (TIPS) rates.

The equity rotation model can allocate between small- and large-cap stocks and growth and value stocks and can take targeted sector positions to enhance returns relative to the broader equity market. As the model is nearing completion, Wu evaluates how it would have performed during previous economic cycles. He runs extensive backtesting and observes the following tendencies of the model in the aftermath of recessions:

· Rotates from consumer discretionary to consumer staple stocks

· Rotates from large-cap growth stocks into large-cap value stocks

· Rotates from small-cap value stocks to mid-cap value stocks

Based on the backtest, which tendency of Wu’s model is he most likely to be satisfied with? The rotation from:

Answer: large-cap growth to large-cap value stocks.

Value tends to outperform growth investing in the aftermath of a recession, so the model is correctly rotating into value from growth stocks. Cyclical stocks tend to outperform non-cyclical stocks in the aftermath of a recession, so consumer staples stocks would be likely to underperform discretionary stocks. In addition, smaller capitalization companies tend to outperform in the aftermath of a recession, so the shift from small- to mid-cap stocks would be sub-optimal for the model.

1.) Where do we know where we are in the business cycle from this problem?

2.) The textbook makes it seem like you would want to be in Value and Consumer Staples at the same time. What exactly is “aftermath”, and so are there 3 stages of the business cycle? Recession, Aftermath, economic expansion? The excerpts from the text make it seem like there are only 2 stages of the business cycle (or certain periods are ambigious on what group outperforms.

Excerpts from Wiley:

“Value outperforms growth in aftermath of recession. Growth outperforms under economic expansion”

“Small-cap outperform large-cap coming out of recession”

“Rotating into growth stocks (from value) at end of recession”

“Rotating into small-cap stocks at onset of economic expansion”

“Shifting into non-cyclical stocks prior to economic expansion”

#2

I know for this question. I focused on all 3 points as indicators of business cycle and is quite understable.

Cons. discretionary (more cyclic) note recommended position for recession.

Large cap growth vs value stocks (fundamentals) straightforward for recession stage switching (escape to safer position).

Small calp (more risky) - large cap (less risky) also understable action.

I was examing this sector rotation in my portfolio during recession and my conclusion is that works if investor recognizes signals of recession among first acters in the market. Those who are late with the sector switching is better to do nothing. Timing is the key (but such is not mentioned in curriculum).

#3

Recession | Recession Aftermath | Expansion ? Value Growth ? Large-cap Small-cap ? Cyclical Non-cyclical I am trying to think about this in a chart. Is there no outperformance during a recession? Is my chart correct? Where exactly is “after-math”. - during a recession? After a recession? Curriculum seems to be all over the board “coming out of, just before, etc” Lastly, I view value, large-cap, as “stable” but cyclical assets as “non-stable” . I feel like this isn’t right that they outperform at same time. I am not arguing with the curriculum. Just trying to make sense.

#4

Cyclical and Non Cyclical should change place. Recession choice in stock picking would be non cyclical ( more defensive). Also fundamental undervalued and/or high dividend stocks.

I am not native English speaker (it causes problems to me during vignette solving) but I would say that recession aftermath means recession consequences in portfolio rebalancing.

#5

Wiley says “Shifting from cyclical stocks to non-cyclical stocks prior to economic expansion and vice versa for recession”. This contradicts what you are saying (but I agree with you)

#6

It makes no sense to me.

I give an example. The most typical. BDI (Baltic Dry Index) for world dry cargo shipping, which is among the most cylcical sector and strongly depends on phase of global production, before global recession in 2007 hit ATH (if I remember about 11000 points). At that moment almost all world dry shipping company was traded also on ATH. As global economy hit the recession a year after, BDI hit ATL and drop to 600 points at one moment. F. ex Dryship, Inc (DRYS, Nasdaq) drop rapidly from about $100 to $5.

#7

I can not find the Wiley errata anywhere and also do not have the curriculum in front of me as I am at work for the next 7 hours. What does the CFAI text say? Or Schweser. Also Flashback, we think non-cyclical and value should outperform at same time which directly contradicts the question/answer. (He would be satisfied with results 1 and 2 not just 2). I am really confused.

#8

I clearly understood material same as my conclusion above, have no access to material at the moment. I must go out. We will continue a bit later.

#9

Schweser

“Corporate earnings may be related to the business cycle. Cyclical industries (e.g., durable goods manufacturers and consumer discretionary) tend to be relatively more sensitive to the phase of the business cycle. Companies in these industries have revenues and earnings that rise and fall with the rate of economic growth. Defensive or non-cyclical industries (e.g., consumer non-discretionary) tend to be relatively immune from business cycle; their earnings tend to be relatively stable throughout the business cycle.”

CFAI Curriculum

“By contrast, some companies, such as airlines, will produce goods or provide services that are extremely sensitive to the business cycle. In difficult economic conditions, consumers are much more likely to postpone or cancel their vacations, or to vacation at home, than to reduce their consumption of toothpaste, and businesses are likely to cut back on airline travel"

Investopedia

“A cyclical stock is an equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies that sell discretionary items that consumers can afford to buy more of in a booming economy and will cut back on during a recession. Contrast cyclical stocks with counter-cyclical stocks, which tend to move in the opposite direction from the overall economy, and with consumer staples, which people continue to demand even during a downturn.” Turbo989 Check once again this source, maybe you dropped prefix counter as counter-cyclical stock whose price impact in recession is opposite. Counter-cyclical is sector which is defenesive by origin and even may outperform during recession. Example: Pharma (during recession and depression Prosac and Valium sales increase), also Tobacco and Alcohol industry (in some countries).

#10

Why is “Rotating from consumer discretionary to consumer staple during recession aftermath” incorrect then? Per the above text from Schweser and CFAI, that comment should be correct. Unless I have zero clue what “aftermath” means.

#11

Consumer discretionary - cyclical.

Consumer staple - non- cyclical

So rotation from 1st to 2nd as recession is ahead should be correct choice.

Must be an error in your example source.

#12

Here I’ve found out about recession aftermath if you are willing to read, I am going take a rest till tomorrow…

http://equitablegrowth.org/great-recession-aftermath-role-structural-changes-play/

#13

I appreciate the link. I sent a question to Wiley to ask if their info is incorrect.

He runs extensive backtesting and observes the following tendencies of the model in the aftermath of recessions:

· Rotates from consumer discretionary to consumer staple stocks

· Rotates from large-cap growth stocks into large-cap value stocks

· Rotates from small-cap value stocks to mid-cap value stocks

Given no other context, and given the fact that Value and Consumer staples should owned at the same time (recession) why is there not 2 correct answers? Can somebody else chime in? Is it the word after-math (i.e. rotating to staples is too late at this point but rotating into value is not)?

#14

Received confirmation from Wiley that the following statement should be reversed:

Shifting from cyclical stocks into non-cyclicals prior to an economic expansion and vice versa for recessions.

I guess that is the risk of using 3rd party materials.

#15

Turbo989

Seems I was wrong here with my interpretation of “recession aftermath” portfolio rebalacing based on sector rotation strategy.

I know that because I answered wrong on such portal test question.

According to curriculum there are, in my opinion, some contradictory P-manager’s actions.

Seems like migrate from consumer discretionary to customer staples, small caps to large caps stocks but also from growth to value stocks.

Since it is not easy to understand concept as PM topic as a whole, I’ve also found that is not well explained in Schweser so I’ve got nothing to left than study certain concepts as “recession aftermath” rebalacing from official curriculum.

Please, check same concept in CFAI curriculum.

#16

It is hard to explain but I figured out the answer re-reading Wiley… I understand it now, there are multiple stages.

#17

So when happens this “aftermath”? In the beginning, in the middle or at the end of recession?

#18

“After-Math” - Time right AFTER recession (and right before economic growth). You want to flip into Value, Small, & Discretionary. This is a very short period of time.

Economic Growth - Time right after “After-Math”. You want to flip from Value to Growth right before. But you STAY in Small & Discretionary.

Now what I can infur is that prior to Recession you want safer assets which are Large, Value, & Non-Discretionary (staples). Owning Value here is not explicitly stated in the curriculum, but it can be inferred because you do not want own growth during a recession. I do not think anything about Recessions will be tested because it is a bit murky. So the fact that the model is flipping into Value prior to After-Math is good (even though you really should be owning it anyway)

Just Remember After-Math and Economic Growth periods.

Recession | After-Math | Growth

Value Value Growth

Large Small Small

Non-Disc Discretionary (cyclical) Discretionary (cyclical)

#19

Perfect. Thus issue is explained. Timing momentum is the key. Dancing on the fire or tobogganing with razor blades under balls. Thxs!

#20

Thank you for the detailed description. Hope a Q will come under this topic