One sector outperforms the stock market 100% of the time when an economic recovery begins, Bank of America says. Where to invest now, and 5 reasons why the downturn phase is over.

  • Investors continue to fret over an economic downturn, but Bank of America thinks otherwise.
  • Bank of America strategists see indications of a recovery, and that means good news for some stocks.
  • Here’s why more cyclical stocks have room to run, as well as the sectors that always outperform.

It’s never easy to predict where the economy will go next, especially these days. With so much reliant on data and the Fed’s interpretation of it, investors have found it difficult to position themselves where the puck is moving, and most have been playing catch-up all year.

In a recent note to clients, Savita Subramanian, Bank of America’s head of US equity & quantitative strategy, wrote that she and her colleagues had compiled a series of economic tells into one comprehensive indicator that can point the way.

“Admittedly, the last few years have not felt well-defined from a ‘cycle’ perspective, with asynchronous upturns and downturns during and after COVID-19,” wrote Subramanian. “However, our US Regime Indicator has remained relevant in capturing factor trends – for example, the January to June Downturn saw megacaps, Growth, and Quality outperform, as expected.”

That indicator has now shifted. Instead of indicating a downturn, the data suggests that the US economy has entered a new phase of the economic cycle.

What happens to the US economy next

Bank of America’s economic indicator has abruptly shifted upwards, from the depths of a “downturn” phase to the gradual strengthening of a “recovery” phase.

This indicator is made up of eight key pieces of macroeconomic data, which are listed below verbatim:

  • Earnings Revision Ratio: the proportion of S&P 500 companies with higher versus lower Thomson Financial consensus earnings estimates. A rising ratio indicates an improving cycle.
  • ISM PMI: Institute for Supply Management Manufacturing Purchasing Managers Index, Z-Score, ISM PMI. The ISM PMI tracks supply management activity as reported by 300 supply management professionals. A reading of more than 50 indicates expansion.
  • Inflation: As a Z-Score, the 12-month change in the BofA Inflation Composite. Rising inflation indicates that economic conditions are improving.
  • GDP Forecast: The Z-Score represents the next 12-month US GDP growth forecast from the Federal Reserve Bank of Philadelphia Survey.
  • Leading Economic Indicators Index (Z-Score): The 12-month change in the Conference Board US Leading Index of Ten Economic Indicators. A rising Z-Score indicates that economic conditions are improving.
  • US Capacity Utilization: Change in US capacity utilization over a 12-month period, expressed as a Z-score.The capacity utilization rate is the percentage of total economic capacity that is used. Rising capacity utilization implies bettering conditions and higher demand.
  • 10-Year US Treasury Bond Yield: The Z-Score represents the 12-month change in bond yield. Rising yields indicate that economic conditions are improving.
  • High Yield corporate bond credit spread: The 12-month change in the ICE BofA US High Yield Index’s credit spread, expressed as a Z-score. Falling spreads indicate that economic conditions are improving.

Three of those data points, according to Subramanian, have decreased month over month: the EPS revisions ratio, leading economic indicators, and the high-yield corporate bond credit spread.

However, five of the eight indicators improved — and they did so for the second month in a row. That tells Subramanian and her colleagues that the economy is changing, and smart investors must prepare for it by looking to the past.

How to invest as the economy recovers

Subramanian noted that when the economy has previously entered a recovery phase, several stock-market sectors have outperformed.

“Sector performance in previous Recoveries was demonstrably pro-cyclical: Financials, Industrials, and Materials fared well, whereas Utilities, Health Care, and Staples underperformed,” Subramanian wrote.

In fact, the financial sector has outperformed in 100% of previous recoveries, while the utilities sector has underperformed in 100% of previous recoveries.

Subramanian went even further, extending the economic regime indicator’s 20-year data set all the way back to the 1970s, when the United States was dealing with a different inflation crisis.

“When the Fed was fighting inflation in the 1970s, it took several hike cycles to bring inflation under control.” Even after the Fed left, Value consistently outperformed Growth for the next 12 months,” Subramanian wrote. “Small Caps mostly led Large before the last hike (except for the last month), stumbled in the three months after the last hike, but then led Large Caps in the six and twelve months.” Bonds generally outperformed equities prior to the last hike, and they have consistently outperformed since (supporting our overweight of the bond-like Utilities sector).”

Of course, a lot has changed since then, especially in the 20 years that Bank of America uses to calculate the economic regime indicator. Subramanian pointed out that the indicator does not take into account factors such as the tech sector’s higher beta in the 1990s or the slowing volatility of energy sector earnings.

However, the indicator has a strong track record of predicting the right investing style. Subramanian noted that the indicator shows that deep value stocks, as well as higher risk stocks, are well positioned to benefit from the economic recovery, despite trailing the market in August.

She also noted that high-dividend-yielding stocks have recently lagged the market, but historically, a recovery phase for the economy has resulted in strong outperformance for the group.

“Highest dividend yielding stocks are neglected (51% underweight by long-only funds), and valuations are two St. Dev. below average, supporting further outperformance in the coming months,” she wrote.

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