I started this blog for a variety of reasons, and one of the most important ones is to consolidate ideas and financial concepts. Today, I’m diving into one of these concepts: the process of economic research.
While this process is foundational in economics, it extends across all social sciences and, surprisingly, it consists of just a few straightforward steps:
- Developing an effective research question
- Surveying existing literature on the topic
- Analysing the issue using economic theory
- Testing the analysis
- Interpreting results and drawing conclusions
- Sharing the findings
To many of you, these steps might sound obvious, but putting basic concepts into practice is extremely useful. This is what today’s article is all about: creating a good habit by implementing the economic research process to a simple financial subject.
Let’s start by introducing our topic.
Since the 19th century, investors have categorized stocks with similar characteristics together, initially by sector and eventually basing themselves on many other traits: market cap, valuation multiples, and even qualitative aspects like Peter Lynch’s six categories.
If you do a quick internet search, you’ll notice that one category that often appears is that of cyclical stocks: companies expected to move with the economic cycle, thriving during booms and struggling in recessions, often facing bankruptcy in severe downturns.
A popular piece of advice is to buy cyclical stocks at the bottom of or right after a recession. The logic? If a cyclical company’s fortune follows the economy, its stock should surge as the economy recovers. Many investors even consider this effect (graph 1) as “free market leverage.”
But is it really that simple?
Let’s find out.
We are going to start our analysis with the first step of the economic research process: developing an effective research question. It needs to be succinct, capturing the entire subject in one or two sentences; for my example, I came up with “Do cyclical stocks systematically outperform the general market right after a recession?”
With our question in hand, let’s proceed to economic theory to build a testable hypothesis that holds up across countries, regions and timeframes.
Cyclical stocks are characterized by volatile profits, given that they typically offer discretionary or luxury goods – products that consumers cut back on during tough times. In theory, stock prices should reflect this cyclicality since investors are forward-looking. However, empirical evidence shows that investors often struggle to forecast future profits accurately, leading to a strong correlation between profit volatility and stock price volatility (De Heer & Koller, 2000).
Given these points, we expect cyclical stocks to be more volatile than the market, moving up and down with the economic cycle. Based on this, our hypothesis is that cyclical stocks outperform the general market after a recession, as profits rebound and valuations adjust.
To test this, I needed data comparing the returns of cyclical stocks versus the overall market immediately after recessions. Unfortunately, reliable data was available only for the U.S. market and just for three recent recessions. Even though this dataset is limited, we can still draw some meaningful conclusions from it.
Here’s the process I followed.
I identified the three most recent U.S. recessions – the COVID-19 recession of 2020, the financial crisis of 2008-2009, and the early 2000s recession. To represent the U.S. market, I chose the Vanguard Total Stock Market Index Fund and used the Vanguard Consumer Discretionary Index Fund as a proxy for cyclical stocks. Although this fund doesn’t directly track cyclical stocks, it closely represents them by focusing on consumer discretionary items. I then compared the two funds’ performances over two years from the official end of each recession.
Now that the playing field is set, we can take a look at the results.
Percentage difference between money invested
at the end of a recession in the market and in cyclical companies
| Region | After 6 Months | After 1 Year | After 1,5 Years | After 2 Years |
| United States | 13% | 20% | 19% | 18% |
The table above shows the combined performance difference between the two funds over the selected periods. As expected, cyclical stocks outperformed the market, delivering an impressive 20% extra return in just one year.
The daily performance (graph 2) reveals that most outperformance occurred in the first few months post-recession, stabilizing at around 20% thereafter. Breaking down the results by each recession (graph 3) highlights further variations: the COVID-19 and 2008-2009 recessions account for the majority of the gains, while the early 2000s recession contributed far less. These differences remind us that each recession is unique. However, across all three cases, the difference remained positive, supporting our hypothesis that cyclical stocks tend to outperform the market post-recession.
Our findings suggest that, at least in this limited dataset, cyclical stocks do indeed tend to outperform the market after a recession. Yet, it is essential to issue a disclaimer: with only three recessions from a single country, our dataset is narrow. While the insights here are valuable, they’re not definitive proof and should be viewed as a basis for more extensive research. Nonetheless, the findings of this research can still give meaningful insights on how stocks and stock returns behave in different market conditions.
One question that might come to mind now is: can this observation inform a profitable investment strategy?
First, I’ll start by saying that this is not the focus point of this article. Nevertheless, even if more specific research is needed, I still don’t think that there is much performance to be gained compared to just holding the market. When I gathered my data, I knew exactly when the three recessions both started and ended but, unfortunately, this is only clear in hindsight. As the data has suggested, missing the start of the strategy even by only a couple of months could make the outperformance disappear entirely. That is a story for another time, but it illustrates the challenge of translating this kind of insight into a reliable strategy.
After this analysis, we have almost completed all the steps of the economic research process: as the final stage, we just need to share the findings of the research project.
You ask how?
Well, through this article of course!
By sharing this exploration, I hope to highlight not only the mechanics of economic research, but also the nuanced reality of investing with cyclical stocks.
With these steps in mind, the process of economic research becomes a fruitful habit, one that helps us turn data into insights, allowing us to make better-informed decisions as investors.