Sir John Templeton is quoted as saying, “The best time to invest is when there is blood in the streets.” Of course, he was speaking metaphorically. His statement is very applicable to our circumstances today.

Many would say we are in the trough of this recession. The trough doesn’t mean the “bottom of the market”, but it does mean the time frame around the end of a recession and the beginning of recovery. I won’t get into whether the recession is over and recovery has started – I don’t know. But it does seem to be becoming accepted that we are in the range of either the end or the beginning (of recession or recovery). So, what does that mean to me as an investor?

Many investors assume that stock returns follow the business cycle. According to this view, the stock market offers a higher expected return premium in a strong economy and a lower premium in a weak economy. (The market premium refers to the return of stocks over T-bills.)

In reality, the market premium tends to run counter to the business cycle, as illustrated in the conceptual graph above. The premium is a function of how investors perceive their risk exposure in equities relative to cash, or T-bills. During recessions, as company earnings fall and investors become more risk averse, stock prices adjust downward, which raises expected returns. The possibility of earning higher returns compensates investors for choosing stocks over cash.

Conversely, investors will accept a lower expected return when they regard stocks as less risky relative to cash (i.e., a lower market risk premium). This typically occurs when the economy is expanding and the outlook for company earnings is strong. As more investors choose to hold stocks, market competition drives up stock prices relative to company performance, which reduces expected returns.

Investors should not attempt to time the business cycle. Economic performance is only known after the fact, while stock prices reflect the market’s view of future business performance. As new information becomes public, stock prices adjust to provide equity investors an expected return that matches perceived risk.

Investors are best served by diversifying across many stocks, maintaining a long-term perspective, and applying discipline throughout the business cycle.

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