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More than 20 months after the Fed started tightening, economic uncertainty remains high and we’re still waiting for the most anticipated recession ever. This quarter, I’ll provide a roadmap for this "late-cycle" environment. First, I’ll consider some of the signs of a late-cycle phase, from liquidity flare-ups to yield-curve inversion, and what they’re telling us about how long it could last. Second, I’ll offer ideas on navigating the late cycle, including thoughts from several senior Wellington PMs, on portfolio positioning, big cycle bets, and security selection.
I think there are pretty clear signs that we are late cycle, as well as some signs that we might remain there for some time to come.
Similarity research — Our Investment Strategy Group has developed a tool for identifying historical periods that are most similar to the current period based on certain market characteristics, such as volatility, yields, and the relative performance of various assets (e.g., growth versus value stocks). Looking back nearly 30 years, they found that the three periods shown in Figure 1 were most similar to the second quarter of 2023, as indicated by the overlap between the colored and the gray areas.
It turns out that the three historical periods were late-cycle periods and, indeed, were close to a market peak — between seven and 20 months away, followed by substantial declines. The most similar period, the first quarter of 2019, was of course followed by the COVID downturn (-20%). Nonetheless, I do think that was a late-cycle period, and perhaps the time to market peak would have been extended if not for the pandemic. The 1998 and 2007 periods were followed by significant equity market declines (45% and 51%, respectively), but in both cases there was still some room to run before the market peak.
Liquidity flare-ups — More anecdotally, I think it’s significant that we’ve seen markets facing liquidity-related issues around some late-cycle periods. In the wake of the 1998 period, for example, we saw credit challenges between 2000 and 2003 linked to fraud and accounting at WorldCom, Enron, and Adelphia Communications. And after the 2007 period, we saw the Bear Stearns mortgage funds go under, as well as problems with the auction-rate preferred securities market and special purpose vehicles (SPVs). This past year, of course, we had the failure of Silicon Valley Bank and other US regional banks, along with Credit Suisse. Again, these may be signals that we’re closer to the end of the late-cycle stage than the beginning, but also that there might be some time before the end.
Early signs of speculative fever — In the late 1990s, investors saw enormous promise in the internet, but some of the big winners weren’t even investable yet. (Google didn’t go public until 2004 and Facebook nearly a decade after that.) In those early days, the public market got ahead of itself with its fervor for some internet stocks that today are largely forgotten. It’s possible that we’ve seen similar speculative extremes recently in areas like crypto, the meme stock phenomenon, and now in artificial intelligence (AI). I have no doubt that AI is going to revolutionize the way we live and work, but there’s also a good chance the market has been overly exuberant about some individual securities.
Sanity check: Recoveries from market troughs — My colleague Brian Hughes, a strategist on our derivatives team, provided another perspective on the late-stage question. He looked at how equities fared over the two years following a bear market trough and found that more than 80% of the time the market was up 50% or more — sometimes much more, as shown in Figure 2. So, if you agree that we had a bear market trough in October 2022, we’re up 30% since then through November 2023. That suggests that we may still have a ways to go to the peak of this bull market and we could be in late stage for a while. (On the other hand, it’s possible — as some of my colleagues have countered — that we’re not in a bull market at all and that the gains over the past year were just a blip in a bear market.)
Yield-curve inversion — There is pretty compelling historical evidence that when the yield curve inverts, a recession is imminent. We saw this, for example, in the early 1990s, the late 1990s, and prior to the 2008 global financial crisis (Figure 3). We saw it again during the pandemic, though the recession was brief — again, something I would chalk up to the unique nature of that event.
That said, the yield curve has been sounding the alarm on recession risk for roughly a year and a half, but the recession hasn’t happened and doesn’t appear imminent. What might explain this? Typically, the yield curve inverts on the back of Fed tightening, and although the Fed began tightening in March 2022, it has been doing so in a very different environment, with monetary policy and especially fiscal policy remaining quite supportive. As a result, Fed tightening may be working but with more of a lag than usual.
One side note on the inverted yield curve: Cash has recently had higher yields than it has in years — in fact, higher than longer-duration bonds. But if we assume the Fed may be nearing (or at) the end of its tightening cycle, there may be a case for considering a shift from cash to bonds. My Investment Strategy colleagues looked at the historical evidence, which you can find here.
Market concentration — Equity market concentration has reached extreme levels, especially in the US, where the “Magnificent Seven” stocks dominated in 2023. Figure 4, provided by Wellington Equity Strategist Andy Heiskell, offers a statistical view on concentration in the S&P 500 going back to the 1960s. As indicated by the gray ovals, interim peaks in this concentration level are often followed by or coincident with a recession. We’re now at a peak that well exceeds the level leading up to the technology, media, and telecom bubble of the late 1990s, which feels like a warning sign.
In thinking about the possibility that we are in a late-stage world and may, in time, need to navigate a market downturn, I’m reminded of a quote often attributed to John Maynard Keynes: “Markets can remain irrational longer than you can remain solvent.” I think that speaks to the need to find a middle ground between what is rational on the one hand and the potential for markets to go to extremes on the other. With that in mind, I want to share insights from several Wellington portfolio managers on navigating a late-cycle environment.
Adam Illfelder, a value equity portfolio manager, offered a number of thoughtful points:
The start of a recession and the bottom of a market may line up — This is a reason to consider preparing for a recession ahead of time. By the time the recession starts, the market may already have bottomed. On the other hand, Adam reminded me of a quote from the economist Paul Samuelson: “The stock market has predicted nine out of the last five recessions.” In other words, markets can sell off for the wrong reasons, a point worth factoring into portfolio decisions at this stage.
We may be in a rolling recession by industry — Adam first observed this in the industrials and durables space — coming out of the pandemic and the related supply chain issues, these sectors in particular were feeling earnings pressure. Then came the challenges faced by banks and other financials in early 2023. This past summer, the consumer discretionary sector was caught up in concerns about weakening consumer spending — given the return of student loan payments, for example. And most recently, the utilities industry has been roiled by rising interest rates.
What to do now?
All in all, Adam’s outlook is better than might be expected. He thinks the “rolling” nature of the recession to date suggests that any broader recession that arrives is likely to be shallow. In addition, he notes that not many industries have been over-earning recently, which should mitigate the chance of a sharp downturn from here. Finally, if mega-cap stocks are excluded, he believes valuations, at right around median, are not overly extended.
With all of this in mind, Adam is trying to be sensitive to the potential timing of a recession and a market bottom by being careful in portfolio decisions not to “pick up nickels in front of a steamroller.” He’s focused on bottom-up analysis and finding stocks that are already discounting a recession. He is also remaining wary of traditional defensive positions — areas like utilities and REITs that might struggle if interest rates remain higher for longer — and focusing on quality.
Kenny Abrams, a 37-year Wellington veteran who manages small-cap and large-cap strategies, focused on the market concentration concern:
Today’s very narrow market is not sustainable — Under the surface, Kenny sees a number of risks that could change the picture, including reduced spending on technology if companies don’t think the productivity gains are there. He also sees regulatory risk driven by the dominance of the “Magnificent Seven,” and he points out that, as he’s seen in previous regimes, even just a change in market leadership can be the catalyst for a bear market.
What to do now?
Kenny is averse to timing the market, preferring to stay fully invested and focus on picking his spots with resilient companies that don’t need to raise equity or debt to deliver on their growth. With companies he already owns, he’s repricing their debt stack at current rates to make sure the business model still works. He’s also being careful about making sector and country bets, which could pose more risk than intended if we end up in a meaningful bear market.
Notwithstanding Kenny’s market concerns, he believes we are entering a “golden age of active management” — a period in which fundamentals truly matter and can point to clear differentiation between winners and losers in the market. Given how much the cost of funding has risen and the need many companies will find they have to deleverage, this could be a moment when active managers can shine at finding those truly resilient companies.
Brij Khurana, who manages opportunistic fixed income strategies, offered a number of differentiated views:
Consider buying market leadership until there is high confidence a recession is materializing — Brij believes that market leadership continues until the cycle has ended. He’s less concerned about narrow market leadership, arguing that’s how cycles work, as prices deviate from fundamentals. That said, Brij believes a recession is imminent and, therefore, that now may be the time to sell market leadership.
Time to position for the next cycle? — In Brij’s view, the current cycle started in September 2020 and the message was “stay out of bonds,” while mega-cap stocks and energy were the big winners. He thinks now is the time to position for the next cycle and sees a clear case for bonds. Part of what’s driving his view on bonds is a belief that there’s a greater risk of a bad economic outcome than is reflected in the markets. While consumer and business balance sheets may be strong, Brij argues they have been propped up by government spending, which is expected to soften. He also worries about the Fed’s reliance on lagging indicators, which could lead the central bank to overtighten or, in the case of an economic slowdown, cut less aggressively than required. Either outcome runs the risk of a significant recession.
What to do now?
Brij believes this is a time for fixed income investors to add duration. He thinks inflation-linked bonds are attractive, particularly if real yields fall — a possibility in a world without much economic growth or productivity. He also favors duration, especially outside of the US, where markets have tightened more and government spending has been less stimulative.
I’m not quite as bearish as Brij. I agree that businesses and consumers have benefited from government support but think we could see another year or two of reasonably strong fiscal spending — enough to postpone a downturn. This suggests that allocators should be prepared for a late-cycle world that persists. That means taking yield-curve inversion with a grain of salt. It’s been 18 months since the curve inverted and we haven’t had a recession yet. It’s certainly possible we could go another 18 months. In terms of specific implementation ideas, I’d offer the following:
Don’t be afraid to react to market concentration — Equity market leadership could remain very concentrated for some time to come. Allocators may want to consider active extension strategies (sometimes called 130/30 strategies). They have the flexibility to short stocks, which means portfolio managers can overweight the stocks they favor without having to underweight (on average) the largest names in the index to source capital. Similarly, long/short strategies that are balanced long and short don’t have the problem of underweighting the mega-cap stocks in order to pick the stocks they want to hold. Lastly, I think there is room for allocators who have the wherewithal to hedge some mega-cap exposure — not to make a timing call, but to make sure their managers’ best security selection ideas are shining through.
Be cautious about big cycle bets — As I’ve noted, the current bull market could easily have a second leg. On the other hand, Brij could be right in his concern that the Fed has tightened too much. So things could swing either way, suggesting this isn’t a moment for big cycle bets.
Focus instead on security selection — Portfolio managers I spoke to made a compelling case for resiliency, whether that means picking stocks where the recession’s priced in or where there’s compelling evidence that a new cycle is already starting. Finally, I think that playing “defense” is always an important idea in the late stage of the cycle, but that may look different today given the unique nature of the market and macro environment. So, allocators should ask their managers how they’re thinking about defense at a time when a more nuanced approach may be in order.
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