ASSET CLASS PERFORMANCE VARIES ACROSS THE PHASES

The performance of other asset classes and investment styles also vary systematically with the phases. Exhibit 5.8 shows annualized real total return for U.S. equities, bonds, and the S&P GS Commodity Index for each of the phases in all of the five cycles. The general conclusions are:

• In the Despair phase a risk averse investor should own bonds, while a less risk averse investor should consider commodities. In this phase, bonds have always outperformed equities and commodities have outperformed equities in four out of five cases. The relative performance of bonds and commodities is more mixed, with commodities outperforming in three out of five cases. On a median basis, commodities have strongly outperformed bonds, but bonds are less risky with the worst annualized return being −3.7% as opposed to −20.2% for commodities. It is not surprising that equities are the poorest performer, since the Despair phase is marked by the move from the peak to the trough of the equity market, but the analysis shows how large the potential is for outperformance by diversifying into other asset classes at this point in the cycle.
• In the Hope phase, equities offer by far the best returns. In this phase there is a clear ranking of the asset classes. In all five cycles, equities outperform bonds and in four out of the five cycles, bonds in turn outperform commodities.
• In the Growth phase, commodities lead. Commodities outperformed both bonds and equities in four out of five cycles. On average commodities outperformed bonds and equities by roughly 10% per annum whereas on a median basis the outperformance was around 3.5% per annum. Both equities and bonds perform poorly in this phase, with the relative ranking being somewhat unstable.

EXHIBIT 5.8 Asset Class Returns by Phase

The general conclusions for asset classes together with the general conclusions for style performance from another study by Nielsen and Oppenheimer³ are summarized in Exhibit 5.9. The conclusions are general in the sense that most patterns are not true in every single cycle in all markets but rather hold in most of the cases.

Typically cyclical stocks underperform defensive stocks in the Despair phase and outperform in the Hope phase. This speaks to the beta-driven environment of those two phases. Later in the cycle this is less important and results are more mixed on this dimension. Small caps outperform large caps in the Hope phase, whereas large caps historically have outperformed towards the end of the cycle in the Optimism phase. As noted in academic literature value stocks tend to outperform growth stocks.⁴ This is particularly pronounced in the Growth phase, where it is true in every cycle and every market that were considered in the analysis. In line with the idea that investors in the Optimism phase extrapolate growth trends beyond what is sustainable, this is the only phase where growth stocks normally outperform.