The Value and Importance of Understanding Cycles in Investing

The Foundation of Market Behavior

Markets are driven by the core principles of supply and demand, human behavior is shaped by fear and greed, and businesses operate on the pursuit of gross margins. Over the last 150 years, despite changing circumstances, these fundamental drivers have remained consistent. It is our firm belief that these forces are the foundation of the cyclical nature of markets and sectors. This paper delves into this hypothesis, exploring how understanding cycles can help investors contextualize risk, improve returns, and navigate market fluctuations with greater confidence.

The Reality of Market Cycles

Investors often discuss markets in terms of long-term returns, focusing on benchmark indices. For example, in the U.S., the S&P 500 is frequently cited for delivering an annualized return of 10.5% over the last 34 years. However, a closer look reveals significant variations within that period:

• 1990-2000: The S&P 500 delivered a robust annualized return of 15.4%.
• 2000-2010: A difficult decade followed, with an annualized return of -0.4%.
• 2010-2020: A recovery ensued, with an impressive 16.1% annualized return.

These fluctuations demonstrate that markets undergo periods of mean reversion—where exceptionally strong returns are often followed by weaker ones, and vice versa.

A similar pattern can be observed in India. The Nifty 50 has delivered an annualized return of 14.4% over the same 34-year period, yet the cycles within reveal distinct phases:

• 1990-2000: An annualized return of 16.5%.
• 2000-2010: A slightly lower, yet strong return of 13.9%.
• 2010-2020: A decade marked by a more modest 8.01% annualized return.

Based on historical trends, one might expect the 2021-2030 period to offer above-average returns, as cycles tend to revert. Understanding these cycles doesn’t provide certainty but does help contextualize risk and align investment strategies with probability-based outcomes.

Key Drivers of Cycles

Three critical factors influence market cycles: valuations, earnings growth, and the macro environment. Each of these elements impacts the quality and sustainability of returns.

Valuations: High valuations require earnings growth to justify them. Over time, valuations and growth tend to revert to the mean, as sustained high growth is rare.

A study of S&P 500 stocks over the past 35 years reveals that only one company has managed to maintain 10% revenue growth over ten consecutive years. This illustrates the natural mean-reverting nature of growth—and, by extension, valuations.

Earnings Growth: While certain sectors or companies may show periods of strong growth, this is rarely linear. Growth often ebbs and flows with broader economic cycles.

Macro Environment: The macroeconomic backdrop—whether inflationary, deflationary, or otherwise—plays a significant role in shaping market cycles and sector performance. Different sectors perform well in different phases of the economic cycle.

Historical Case Studies: US Market Cycles

Understanding cycles helps investors identify which sectors and companies are likely to outperform during different phases.

• 2000-2010 (Inflationary Cycle): This decade was marked by global inflation, favoring cyclicals such as commodities and energy. Companies like Freeport-McMoRan, for example, delivered a staggering 1850% return over the period.
• 2010-2020 (Deflationary Cycle): In contrast, the following decade saw global deflation, and technology stocks performed exceptionally well. Apple, for instance, delivered a return of 1900%, with volatility that was half that of the broader S&P 500, resulting in one of the best risk-adjusted returns of the period.

Indian Market Cycles and Sectoral Insights

The same cyclical behavior is observable in India, where macro factors often lead to more exaggerated market movements due to higher volatility and valuation sensitivity.

• 2000-2010 (Inflationary Cycle): India saw a 13.9% annualized return, with cyclicals like ABB benefiting from the inflationary environment, delivering a 31.4% CAGR during this period.
• 2010-2020 (Deflationary Cycle): A more subdued decade, where the Nifty 50 delivered 8.01% annualized returns. During this time, consumer-facing and technology companies, such as Asian Paints, generated significant alpha. Asian Paints achieved an impressive IRR of 29% over this period, highlighting the importance of understanding macroeconomic shifts when positioning portfolios.

The Role of Cycles in Portfolio Management

While bottom-up stock picking is crucial for alpha generation, understanding cycles helps investors align their portfolios with prevailing macro trends, enhancing both returns and risk management.

1. Risk-Adjusted Returns: Investors often focus solely on returns, overlooking the importance of risk-adjusted returns. Understanding cycles helps manage portfolio volatility, allowing for better holding power and improved long-term outcomes.
2. Sector Rotation: Different sectors perform well in different parts of the economic cycle. For example, cyclicals perform better in inflationary environments, while consumer and tech stocks thrive in deflationary periods. This knowledge allows investors to tactically rotate sectors, improving their overall return profile.

Balancing Alpha and Risk

At Itus Capital, our objective is two fold: generating alpha while delivering superior risk-adjusted returns. Understanding market cycles plays an integral role in achieving these goals. While strong stock-picking abilities are vital, the knowledge of cycles ensures that investors can align the odds in their favor, making informed decisions that maximize returns while managing risk. The ability to be truly long-term comes with a dual edge of strong focus on fundamentals alongside an ability to manage risk through positioning portfolios towards the right cycle.

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