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”