Evaluating investment decisions based on the business cycle: a South African sector approach
Abstract
The top-down investment approach is a practice implemented by investors to achieve superior returns. Stovall (1995) proposed sector investing (cycle theory) to guide investors in their identification of undervalued (and thus potentially higher-yielding) securities for inclusion in their portfolios. Sector investing is vulnerable to the misidentification of the business cycle, potentially leading to the subsequent incorrect demarcation of the six business cycle phases (Stovall, 1995). Securities selected from sectors at the wrong phase of the business cycle might lead to inferior portfolio assembly. This could result in unrealised profits or even potential losses. Fourier analysis was used to identify and isolate the South African business cycle (and hence, the component phases of the business cycle). Securities were selected from the relevant phases according to Stovall (1995) and the performance of the resultant portfolios were analysed in historical periods. Sector performance evaluated during its relevant business cycle phase (as suggested by Stovall, 1995), was statistically compared with remaining sectors' performances. The results indicate that in each case, Stovall's (1995) proposed sector performance is the superior one. This suggests that cycle theory remains a profitable practice and is superior to the market benchmark (ALSI). Application of the various performance measurement ratios (Sharpe, Treynor, Jensen's Alpha, Omega and Information) led to the conclusion that the potential exists for implementing an enhanced portfolio selection (i.e. the inclusion of certain securities and the exclusion of others improves portfolio performance). These performance measures further verify that the optimal portfolios were deemed 'superior'; according to cycle theory.