Sector Performance Across Business Cycles November 2009

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1 Sector Performance Across Business Cycles Introduction In this Research Bulletin, we eamine the co-movement of sector returns with business cycles in a global contet, using long run historical data between 1976 and We develop an approach that allows us to classify sectors as defensive or cyclical, based on the strength of this comovement. We also look for signs of different behavior among four regions: developed markets (represented by the MSCI World Inde), USA, Europe, and Japan. We then use this framework to eamine the relative performance of cyclical and defensive sectors over the last 33 years. Some of the eisting literature on this topic defines economic epansions and contractions according to changes in gross domestic product (GDP) or references the National Bureau of Economic Research (NBER) business cycle definitions. This literature finds that the ecess returns of a sector rotation strategy are not significant (for eample, Stangl et al. (2009)). In our study, we use the Organization for Economic Cooperation and Development s (OECD) leading economic indicator series to define epansions and contractions (as stock prices usually anticipate economic up-and downturns). When defining business cycles in this way, we find that performance differentials between cyclical and defensive sectors are important. Identifying cyclical and defensive sectors To identify cyclical and defensive sectors, we measure the correlation between a sector s relative performance to the market and the year-on-year change in the leading economic indicator of the corresponding region. Sectors are defined in our analysis by the top-level layer of the Global Industry Classification Standard (GICS ) that assigns companies to 10 economic sectors. Before 1994, these definitions are etended by mapping the previous MSCI industry classification to GICS sectors. Business cycles are measured by the year-on-year change of the Composite Leading Indicator (CLI) series of the OECD. 1 We epect the cyclical sectors relative performance to the market to be positively correlated with the rate of change of the CLI, and the defensive sectors relative performance to the market to be negatively correlated. We compare the MSCI World Inde to the OECD Total CLI series and the MSCI Europe Inde to the OECD Europe CLI series. The MSCI USA and MSCI Japan Indices are in turn compared to the corresponding country CLI series. The epected relationship can be evaluated by calculating correlation coefficients between the year-over-year relative performance of each sector with its parent inde and the year-over-year change of the CLI. Ehibit 1 summarizes these relationships and helps assess the cyclicality of sectors across regions. Ehibit 1: Correlation coefficient between the year-over-year relative performance of the regional sector inde to its parent inde and the year-over-year change of the corresponding OECD CLI inde Inde Energy Materials Industrials Consumer Consumer Discretionary Staples Health Care Financials IT Telecom Utilities MSCI World MSCI USA MSCI Europe MSCI Japan Source: MSCI Barra and OECD, monthly data 1 Sector data and the OECD CLI series are described in more detail in the Appendi and References MSCI Barra. All rights reserved. 1 of 8

2 For each region, the top three correlated sectors are shaded in dark green and the bottom three in light green. These demonstrate the strongest cyclical or defensive characteristics. We can infer from Ehibit 1 that a clear homogeneity eists across different regions among the three most defensive sectors: Consumer Staples, Health Care, and Utilities. The picture is less clear on the cyclical side. Absolute values of correlations are generally lower, and only the IT sector stands out as a clear cyclical sector across all regions. Materials, Industrials and Consumer Discretionary are among the highest correlated sectors, although their ranking varies across regions. Japan is an eceptional case in that both Industrials and Consumer Discretionary have small negative correlations, indicating that these sectors have historically tended to slightly underperform the market during economic epansion. The absolute values of correlation coefficients are lower for the Financials, Telecommunication Services, and Energy sectors (again, Japan s Financials sector is an eception). Thus, these sectors do not clearly demonstrate cyclical or defensive characteristics. Based on the above results, we can infer that Consumer Staples, Health Care, and Utilities are the most defensive sectors and Materials, Industrials, and Information Technology are the most cyclical sectors. One could argue that the CLI and relative sector performance series do not always move proportionally to each other, and so the choice of the correlation measure is inappropriate. To address this, we also measured the frequency with which the two series change in the same direction regardless of the magnitude of change. The results confirmed our previous findings. Based on our results, we construct two kinds of market capitalization weighted, aggregate cyclical and defensive sector indices. The first one only includes the top three cyclical (defensive) sectors; the second includes all the cyclical (defensive) sectors for each of the four regions a sector being defined as cyclical (defensive) if it has a positive (or negative) correlation with the corresponding OECD leading indicator in Ehibit 1. Thus, in the first version we are considering only sectors with the most pronounced cyclical and defensive characteristics, leaving out some sectors. In the second version we account for all sectors, completely segmenting the market. We refer to these aggregate indices as top three cyclical (top three defensives) and all cyclical (all defensives) respectively. The top three cyclicals aggregate for the MSCI World Inde includes the following sectors: Industrials, Consumer Discretionary, and Information Technology. The all cyclicals aggregate also contains the Materials and Financials sectors. The top three defensives aggregate for the MSCI World Inde contains Consumer Staples, Health Care, and Utilities sectors. The all defensive version also contains Energy and Telecommunication Services. In Ehibit 2, we display the relative performance of these two cyclical and defensive aggregates to each other and show that these series move in lockstep with the change in the OECD Total CLI inde MSCI Barra. All rights reserved. 2 of 8

3 Ehibit 2: Year-over-year relative performance of the two cyclical and defensive aggregate sector indices based on the MSCI World Inde and year-over-year change of the OECD Total CLI 100% 80% 60% 40% 20% 0% -20% -40% -60% -80% -100% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% World top 3 cyclicals / top 3 defensives yoy change OECD - Total CLI yoy change (right ais) Source: MSCI Barra and OECD World all cyclicals / all defensives yoy change Sector returns during economic epansions and contractions We can evaluate the efficiency of the selection method developed above by calculating the ecess return to the market of different sector aggregates during economic epansions and contractions. In Ehibits 3 and 4, we show the relative returns to the market of the top three cyclicals and top three defensives aggregates as well as that of all cyclicals and all defensives during periods of increasing and decreasing CLI indices. We also display the relative performance of these sector aggregates. Each month of the 33-year period is classified either as an up or down month, according to the change in the CLI during that month. An up month is associated with an increase in the CLI and thus with an (anticipated) epansion of the economy. The opposite holds true for a down month. All figures are annualized returns over the totality of up and down months. For sectors identified as cyclical and defensive in Ehibit 1, we highlight entries where the relative over- or underperformance is statistically significant. 2 Ehibit 3: Average sector aggregate relative performance during periods of increasing CLI inde Parent inde Top 3 cyclicals Top 3 defensives Top 3 cyclicals / top 3 defensives All cyclicals All defensives All cyclicals / all defensives MSCI World 4.8% -6.5% 12.2% 3.3% -5.2% 9.1% MSCI USA 6.2% -7.7% 15.0% 4.5% -6.1% 11.5% MSCI Europe 3.4% -1.7% 5.9% 2.2% -2.2% 4.9% MSCI Japan 3.1% -5.8% 11.0% 3.1% -0.2% 4.1% Source: MSCI Barra and OECD; annualized values, based on monthly returns 2 At a 5% significance level using a one-tailed t-test MSCI Barra. All rights reserved. 3 of 8

4 Ehibit 4: Average sector aggregate relative performance during periods of decreasing CLI inde Parent inde Top 3 cyclicals Top 3 defensives Top 3 cyclicals / top 3 defensives All cyclicals All defensives All cyclicals / all defensives MSCI World -5.6% 10.3% -14.5% -4.2% 7.3% -10.7% MSCI USA -5.0% 10.4% -13.5% -4.7% 7.3% -10.8% MSCI Europe -5.4% 7.1% -11.2% -4.3% 5.8% -9.3% MSCI Japan -3.3% 9.7% -11.1% -3.3% 3.8% -6.4% Source: MSCI Barra and OECD; annualized values, based on monthly returns The relative annualized performance of the top three cyclical to the top three defensive aggregates of the MSCI World Inde was 12.2% during epansions and -14.5% during contractions. If we segment the whole market, relative performances are lower: all cyclicals outperformed all defensives by 9.1% during epansions and underperformed by 10.7% during contractions. The large majority of the return differentials are statistically significant for both types of aggregates. Long-term performance of cyclical and defensive sectors We now apply our classification to show the distinct performance of the aggregated cyclical and defensive sectors across different regions over a long time horizon. Ehibit 5: Relative performance of the regional cyclical and defensive aggregate indices MSCI World top 3 cyclical / top 3 defensive MSCI Japan top 3 cyclical / top 3 defensive MSCI USA top 3 cyclical /top 3 defensive MSCI Europe top 3 cyclical / top 3 defensive Ehibit 5 shows that over the last 33 years, cyclicals across all regions have cumulatively underperformed defensive sectors by 40-70%. Additionally, we find several periods where cyclical and defensive sectors had markedly different performance MSCI Barra. All rights reserved. 4 of 8

5 Notably, cyclicals underperformed defensives over nearly two decades from 1976 until 1998 in the United States and Europe. This was followed by a four-year period from 1998 to 2002 during the dot-com bubble, where cyclical outperformed defensive sectors. During the most recent crisis, we can also observe an underperformance of the cyclical sectors starting in mid 2008 and lasting until February This is followed by a strong recovery of the cyclical sectors. In the case of Japan, cyclicals underperformed in the 70s and then outperformed in the 80s and mid 90s during the Japanese asset price bubble, and subsequently again during the dot com bubble. Conclusion We analyzed the relationship between the performance of economic sectors and business cycles, and developed a framework to classify sectors into cyclical and defensive categories. Based on our analysis, the sectors of the MSCI World Inde with the strongest cyclical behavior are Industrials, Consumer Discretionary and Information Technology, whereas Consumer Staples, Health Care and Utilities show the strongest defensive characteristics. The relative performance of cyclical and defensive sectors based on this classification closely tracks the economic cycles. We found significant performance differentials between cyclical and defensive sectors and showed that these are more significant if we do not segment the whole market but only take the top three sectors when defining the cyclical and defensive aggregates. Lastly, we found that over a long horizon of 33 years, defensive sectors have significantly outperformed cyclical sectors. References Stangl, Jeffrey, Ben Jacobsen, and Nuttawat Visltanachoti (2009), Sector Rotation over Business Cycles (SSRN). OECD (2008), OECD System of Composite Leading Indicators, MSCI Barra. All rights reserved. 5 of 8

6 Appendi 1: Linking the previous MSCI industry classification to GICS sectors For the period from August 1976 until December 1994, the 10 GICS sector returns were simulated using returns from the previous MSCI industry classification scheme consisting of 38 industries. The table below describes this mapping. Energy Sources Energy Equipment & Services Chemicals Forest Products & Paper Metals - Non Ferrous Metals - Steel Misc. Materials & Commodities Gold Mines Building Materials & Components Aerospace & Military Technology Construction & Housing Electrical & Electronics Industrial Components Machinery & Engineering Business & Public Services Transportation - Airlines Transportation - Road & Rail Transportation - Shipping Wholesale & International Trade Multi-Industry Appliances & Household Durables Automobiles Recreation, Other Consumer Goods Tetiles & Apparel Broadcasting & Publishing Leisure & Tourism Merchandising Beverages & Tobacco Food & Household Products Health & Personal Care Banking Financial Services Insurance Real Estate Data Processing & Reproduction Electronic Components, Instruments Telecommunications Utilities - Electrical & Gas Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials IT Telecom Utilities Appendi 2: Composite Leading Indicator series of the OECD The OECD calculates and publishes its Composite Leading Indicator (CLI) series that are designed to provide early signals of turning points (peaks and troughs) between epansions and slowdowns of economic activity (OECD, 2008). According to the OECD, the CLI series helps identify qualitatively different phases of the business cycle. A positive rate of change in the CLI is associated with an improvement in the economy (epansion or recovery), whereas a negative rate of change is a sign of deteriorating business conditions (downturn or slowdown) MSCI Barra. All rights reserved. 6 of 8

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