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The Case for Defensive Positioning

•    The Yield Curve, Inflation and Employment are foundational for understanding the business cycle.
•    Filtering today’s circumstances through a historical context with respect to these three indicators advocates a defensive equity positioning.

Inflation and Employment form the foundation of the Federal Reserve’s dual mandate due to their significance in the business cycle. Historically, inflation peaks and unemployment bottoms late in the cycle and both reverse course more coincident with a recession. The Yield Curve, considered the most potent leading indicator of a recession, depicts the market’s forward looking view and historically becomes inverted in the late stages of the business cycle as the Federal Reserve raises short-term interest rates and investors purchase long-dated treasuries for protection against disinflation.

We used these three indicators to create a historical distribution of one-year forward returns of the S&P 500 Index given the position of each indicator and the results support a defensive equity positioning.

To illustrate this point, let’s begin with the Yield Curve. The following graphs display the distribution of one-year forward returns provided a normal, upward sloping Yield Curve versus an inverted Yield Curve. With the normal Yield Curve, we have a positively skewed distribution with a mean return of 13.4% and a positive return over 81% of occurrences.

20230516-chart-1-01 All in all, it is difficult to be bearish given an upwardly sloping Yield Curve. However, an inverted Yield Curve is a bit more challenging. In this case, we see a less skewed, bimodal distribution with returns clustering around a negative peak and a positive peak. On its own, this scenario presents much more of a coin flip for equity investors with positive returns occurring only 53.7% of the time. Let’s next observe how the returns’ distribution changes as we consider inflation and employment.

Historically, future stock returns are positively correlated with the unemployment rate. So as the unemployment rate drops, so do expected future returns. While this may seem counterintuitive, this is because tighter labor markets are generally a late cycle phenomenon. The chart nearby demonstrates this observation:

20230516-chart-2-01Which brings us to today’s backdrop. In conjunction with an inverted yield curve, we currently have a very low unemployment rate (3.5%) and inflation (5%) much above the Federal Reserve’s target rate of 2%. If we add a tight labor market (unemployment <5%) and high inflation (CPI >2.5%) to our data sample, the forward returns distribution skews even more negatively.20230516-chart-3-01More ominously, thus far this scenario only coincides with periods that featured major drawdowns in the S&P 500 as shown nearby. However, the lack of distinct periods characterized by this same macro situation leads to the problem of overfitting a model to a small sample size. 20230516-chart-4-01Furthermore, we could easily data-mine for other current macroeconomic statistics that paint a more benign picture. We should also recognize that equity markets are a parimutuel betting system whereby investors continuously assign probabilities to outcomes, and so we must consider how much downside is currently priced into the market. All things considered, although we remain unconvinced of the absolute power of this model, we still believe defensive positioning is warranted given the track record of these indicators and their fundamental links to the real economy. While we can never expect to time markets, we believe there are better times to take an aggressive investment approach.

Important Disclosures & Definitions

Consumer Price Index (CPI): a measure of the average change over time in the prices paid by urban consumers for a representative basket of consumer goods and services.

S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. 

Unemployment Rate: the number of unemployed as a percentage of the labor force. Labor force data are restricted to people 16 years of age and older, who currently reside in 1 of the 50 states or the District of Columbia, who do not reside in institutions (e.g., penal and mental facilities, homes for the aged), and who are not on active duty in the Armed Forces.

Yield Curve: a graphical representation of the yields (y-axis) on debt instruments with different maturities (x-axis).

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

One may not invest directly in an index.

AAI000269  09/30/2024

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