Nowadays, economic instability is commonly associated with business booms and recessions. We have become accustomed to speaking about these vicissitudes in economic fortune as the "business cycle". Business cycles are the results of cyclical changes in major macroeconomic forces of the economy. These forces are responsible for alterations in the "fundamentals" that affect asset prices. Thus, it is not surprising that research on asset valuation overwhelmingly finds a positive and statistically significant relationship between various assets and the state of the economy. Each asset has unique cash low and risk characteristics during different phases of the business cycle.
Owen and Griffiths (2006) stated that business cycle analysis provided investors with a compass reading the whereabouts of the global markets. This is essential information they need before they start making decisions on the appropriate allocation of assets--equities, bonds, cash and other investments--within their portfolios. It also helps in determining geographic weighting. By setting stock selection within the context of cycle analysis, investors will know whether it is appropriate to chase momentum or pursue a more defensive strategy. To approach the business cycle, investors may choose from two ways one of which is to attempt to spot the turning points and shift asset allocation between various asset classes accordingly and the second is to ignore the business cycle completely and concentrate on picking good companies or identifying investment themes.
Many global asset classes in the 20th century produced spectacular gains in wealth for individuals who bought and held those assets for generational long holding periods. However, most of the common asset classes experienced painful drawdowns, while others complete elimination of wealth. Indeed, many investors can recall horrific 40-80% declines they faced in the aftermath of the global stock market crash only a few years ago. Thus, the main problem of this work is closely connected to the problems that face investors--the maximization of profit and the minimization of risk. The object of the thesis is the historical performance of asset classes and OECD Composite Leading Indicators. Accordingly, the main goal of this work is the integration of the business cycle approach to the construction of optimal investment portfolios.
The paper combines business cycle, asset allocation and portfolio optimization theories by presenting a new model of the investment process and adding valuable information about the performance of asset classes in different phases of the business cycle. It also demonstrates how to use the business cycle approach to investment decision making. 6 asset classes, including US stocks, EAFE stocks, bonds, gold, real estate and commodities have been applied in the conducted analysis.
Research methods used in this paper are the logical analysis and synthesis of scientific literature, the comparison and generalization method, statistical analysis and optimization taken on the grounds of the OECD Composite Leading Indicator approach.
1. Literature review
Academic literature contains much evidence that the expected returns and volatility of asset classes vary through time. Moreover, in high-volatility environments across the world, not only do equity returns perform poorly, but they also become more highly correlated.
In their study, Van Vliet and Blitz (2011) state that the risk and return properties of asset classes are highly dependent on the prevailing business cycle phase. Risk tends to go up in bad times, which is undesirable for a risk averse investor. Besides risk, the average return of many assets is also found to be highly dependent on the economic cycle phase. Most assets exhibit above-average returns during recessions and recoveries and below-average returns during expansions and peaks.
The results obtained by Nyberg (2012) also show that the strength of risk aversion appears to be significantly higher in the recession period compared with the expansion one. …