Let’s take it from the top. The top of the cycle, that is. As the market corrects, anticipating a roll-over in the economy, investors behave in a way you would expect any rational, thinking person to do: either they abandon the equity market – if they haven’t already – or they seek out companies that will navigate the coming period of economic distress with as much certainty as possible, if they haven’t bought into such companies already. Both actions result in cash and/or high-quality companies outperforming the broad market index, as well as cyclical, low-quality (marginal) companies. The outperformance of cash and high-quality equities over the market and low-quality companies reaches its apex at the trough of the cycle, and slowly (over the ensuing three or so years) narrows, as investors anticipate and observe a recovering economy through personal experience and news flow. Our empirical analysis of the performance of high-quality companies over cyclical companies bears this out. Indicatively, Figure 1 shows that high-quality companies gave you enormous protection – with no use of derivatives – against the market crash and economic malaise that followed for three years.
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