https://www.publish0x.com/bringing-us-treasurys-onto-the-chain/business-cycles-and-market-volatility-xmyzvgk
https://www.publish0x.com/bringing-us-treasurys-onto-the-chain/business-cycles-and-its-impact-on-credit-risk-xpzwkkw
https://www.publish0x.com/bringing-us-treasurys-onto-the-chain/business-cycles-and-fixed-income-securities-xeegkwp
Over 20th century equities on average yielded more return than bonds. This is because uncertainty about the future creates more volatility about equity returns than bond yields. An excess return that the stock market provides over risk-free rate (which is typically a yield of a government bond) is referred to as equity risk premium.
During the pre-World War II period inflation was close to zero over long stretches of time. Since coupon payments of most fixed-income securities are not inflation-adjusted, inflation uncertainty is more detrimental for bonds than equities. As a result, bond yields volatility was much lower than equity returns volatility during this era. In contrast to this period, Keynesian era has seen more volatile inflation which increased the volatility of bond yields. At the same time, more active monetary and fiscal policy to reduce the effects of business cycles decreased the volatility of equity returns. This narrowed the spread between volatilities of bond and stock markets. The falling spread decreased equity risk premium.
Dividend yield
There has been a relationship between bond yields and dividend yields historically. The chart below shows that the dividend yield has been higher than 10-year yield until 1960s when the relationship changed. The anchor for equity valuation during that period was the dividend yield: when the yield was higher than the bond yield, it would make sense to buy equities because they were considered undervalued. As already explained, in the pre-Keynesian world bond yield volatility was insignificant because inflation was close to zero. However, in the era of fiat money inflation soared which was much worse for bonds than equities.
In the late 1950s 10-year yield rose above the dividend yield. Though this signaled that equities were overvalue, it this was followed by one of the strongest stock bull markets. It means that something changed in the dividend yield?—?Treasury yield relationship.
Pre-World War II world, when a deflation was not an occasional phenomenon, the source of yield for investors was the dividend yield. Since deflation is detrimental to the stock market, investors couldn’t rely on stock price appreciation. So, to incentivize investors to invest in equities, the dividend yield had to be higher than the bond yield.
Another factor explaining the shift in this relationship is how equities and bonds change their value in a highly inflationary environment. Bonds will depreciate more in real value because their maturity is fixed. This implies that the bond yield has to increase to offset the loss due to inflation. Conversely, dividends don’t have an expiry date. Therefore, they can rise as a response to inflation. Stock prices can also increase in an inflationary environment, which suggests that the dividend yield can remain the same and still compensate investors for inflationary losses. The result is what we already stated above?—?the dividend yield remained constant while the Treasury yield rose in the Keynesian world.
Profits cycle
Corporate profits tend to grow in line with nominal GDP. Indeed, the relationship between the growth rates of profits and nominal GDP is not the same across all period. During some periods, such as the late 1990s and early 2000s, the stock market experiences a bubble which causes profits increase more than GDP. During some periods, such as 1972–1981 when the US economy experiences a persistent inflation, nominal GDP growth was higher than profits growth. Profits tended to grow more in lower positive inflationary environments. Conversely, deflationary and highly inflationary periods were detrimental to profits growth.
Despite this structural trend, profits exhibit more volatility than GDP. In the early recovery phase, when the economy come out of the recession, profits tend to increase faster than GDP. During the late phase of expansion this uptrend slows down. Finally, during a recession profits fall more than GDP.
These cyclical swings in profits growth affects equity prices cycle too. Since profits fall below their long-term growth potential during recessions, they become depressed and undervalued. Which means the best time to invest in equities is when the recession is close to end. When there is a “light at the end of the tunnel”, when the first signs of recovery are seen in the economy, it makes sense to be invested in stock market. The recession is followed by the recovery phase when (especially during the first two years of the phase) equities show highest cyclical increase in price. In fact, the stock market is one of variables in the index of leading indicators because equity prices bottom several months before the recession ends.
Performance of sectors over the business cycle
Like the stock market itself, sectors also respond differently to different phases of the business cycle. There are many factors that can affect the performance of sectors. For example, the housing cycle affects the performance of housing-related sectors, such as housing finance. The performance of industries dependent on borrowing are in line with the credit spread cycle. Some sectors, such as utilities, are more sensitive to changes in interest rates than others. That’s why it is difficult to separate the impact of the business cycles from other economic factors. However, some relationships have been observed between the business cycle and the performance of various sectors.
Performance of some parts of the economy, the so-called “defensive sectors”, show less cyclicality than others. These sectors are health care, consumer staples, and utilities. These sectors tend to be stable even during recessions, thus overperforming other equities during hard times. Since they are less sensitive to the overall market performance, they have a below-than-average beta.
On the contrary, equities of cyclical sectors have higher-than-average beta which means their share prices change more relative to the overall market performance. Consumer discretionary, financials, energy, materials and industrial companies are cyclical sectors. Companies in these sectors perform well when the economy recovers or expands. Thus, they have more volatile revenues than defensive sectors.
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