- Cyclical stocks have historically shown great sensitivity to economic growth and served as reliable forward-looking indicators of both market and economic recoveries.
- Since the market's bottom in March, cyclicals have mostly underperformed the broader market and are signaling to Societe Generale strategists that the recovery is not as airtight as the rally indicates.
- Their trajectories after the 1929 and 1932 market downturns provide templates for how this recovery may unfold.
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Stock-market investors got two doses of reality last week that interrupted a seemingly unstoppable rally.
They came via warnings of a prolonged economic recovery from the Federal Reserve chairman, and a rise in new coronavirus infections and hospitalizations in states that are reopening their economies. The newsflow culminated in the S&P 500 recording its longest daily losing streak since the thick of the crash in March.
This brief sell-off notwithstanding, investors have been grappling with the question of whether the market's roaring comeback from its 33% decline was too far ahead of economic reality. Quantitative strategists at Societe Generale dove into history to come up with an answer — and what they found is yet another gut check for the bulls.
The team led by Andrew Lapthorne examined the market crash of 1929 that preceded the Great Depression, as well as the one that followed in 1932. Their aims were to discover how the market advanced from its bear-market bottoms, how those compare to the 2020 rally, and what the results suggest about the months ahead.
They handpicked those two years because investors faced nearly identical economic conditions but played the recoveries very differently.
Cyclicals told you what happened next
More than any other class of stocks, cyclicals that are sensitive to economic growth were accurate prognosticators of what followed in both instances.
Cyclicals fell more than 35% in the first year after the 1929 market bottom. Meanwhile, the broader market ripped nearly 50% in the first four months from the bottom. But if you were paying attention to cyclicals, you may have sniffed out the bigger crash that followed.
Stocks eventually bottomed in 1932, when cyclicals staged a persistent rally that added up to 200% within the first year of the trough.
The contrasting trends in cyclicals are shown in the chart below.
It's worth acknowledging the privilege of hindsight we have now, although it could equally serve as a cautionary tale for the future.
"The weak and whipsawing of cyclical performance we saw in the weeks until this last one, which is far short of the classically clear resurgence that we observe in genuine recoveries, as cyclicals' vote of confidence to an upcoming economic recovery could indicate how fragile the underlying economic recovery might be and raises questions about whether the worst is over for the markets," Lapthorne said in a recent note.
He added that continued gains in cyclicals would be an encouraging signal for the strength of the recovery. However, the trend so far has largely been more similar to 1929 than 1932.
Lapthorne noted that other equity factors which historically trend in certain ways were consistent with the messages cyclicals sent in 1929 and 1932.
The size factor — which involves a strategy of buying small-cap stocks and selling large-cap — fell by as much as 40% from its trough in 1929 but exploded 250% within two years after 1932.
Small caps are similar to cyclicals in that they are also sensitive to economic growth. And in 2020, they largely lagged the broader market from the March low until mid-May.
Put together, the recent gains for small-cap and cyclical stocks in 2020 could be interpreted as strong, forward-looking signals of the economy's v-shaped rebound. And on some level, it's not worth fighting the broader uptrend.
But Lapthorne is erring on the side of caution before jumping to any firm conclusions. After all, the economy is still in recession, consumer demand has not recovered, and there's a weight of uncertainty about the pandemic's future. All these risk factors were largely sidestepped by investors until last week.
If the Fed is talking about "a long road" to recovery even with full knowledge of the resources at its disposal, perhaps investors should embrace that mindset, too.
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