We’ve got an excellent piece from Edinburgh Partners for our Fund Manager’s Corner. As part of his quarterly report, Dr. Sandy Nairn, the founder and President of the firm, provides some excellent background on economic and market cycles. The piece comes at the topic from a global perspective, which we all need, and it helps us understand how Edinburgh Partners thinks about stock selection and market inefficiencies. - Tom

For 'New Paradigm' Read 'Decoupling'

At the risk of being overly simplistic, it is worth setting out a number of key relationships which markets seem repeatedly to forget.

Company operating margins are directly correlated with economic growth. When economies are growing, companies are able to produce greater volumes without having to increase the assets employed proportionately. Profits therefore rise not just because sales are higher, but also because margins are higher. Few companies or industries are exempt from this relationship. The only question is the degree to which they are impacted.

  • Emerging markets companies tend to be more affected because they are growing faster;
  • Small and mid-sized companies tend to be more affected because they are growing faster;
  • Companies producing bulk homogeneous products where pricing power is weak, such as paper, steel, chemicals, oil, metals, tend to be affected more. Indeed this relationship is used to describe them – cyclicals
  • Companies dependent upon discretionary expenditure are impacted more because discretionary expenditure is reduced when conditions toughen.

Companies where both the end demand and margins are more stable are clearly less impacted. It is not that there is no impact; it is just that the effect is less.

While this may appear startlingly obvious, it lies at the root of why market anomalies appear. All the evidence points to the fact that market imperfections derive from the inability of investors to work with a sufficiently long time horizon. Often this manifests itself in confusion about what is sustainable and what is not. This confusion is typically exacerbated by an elegant argument over why ‘this time it’s different’ (aka ‘new paradigm’, ‘decoupling’).

Putting this another way, because of stock market myopia, typically what share prices discount is a continuation of whatever has happened recently. Most of the time this extrapolation is not a bad approximation of what happens next, which is why it tends to persist. However, when it is wrong, it is very wrong. The time when it is most wrong is when economies are turning.

The Economic Cycle and Forecasting Errors!

When economic conditions are rough or recessionary, companies margins will be low, sales growth will be slow or negative, and profits will be poor. However optimistic analysts are, their expectations will be deflated and the valuation that the market puts on profits (the P/E ratio) will consequently be low.

When economic conditions have been buoyant for a while, margins will be high, sales growth will be strong and profits will be good. However pessimistic analysts are, their expectations will remain inflated and the valuation that the market puts on profits (the P/E ratio) will be high (see chart). This is not logical – P/Es should logically be lower at market peaks, when shares are dear, and higher at market lows, when shares are cheap - but it is what happens through every market cycle.

I should apologise for spelling this out in such a pedantic manner, but it is important, as it goes to the root of why we can see such violent moves in markets and how money can be made if one has the correct time horizon. Critical to this of course is a recognition that the economic cycle is not, has never been, and never will be, abolished. Equally important is fundamental economic truth that ‘everything is related to everything else’. Much as it may be wished for, economies are inter-related, as are companies, as are industries. They do not ‘decouple’ and hence one cannot and should not treat the potential downturn in a major economy as being an isolated event which will not impact the rest of the world. To do so is simply wishful thinking and a subset of the ‘this time it’s different’ category.