A characteristic common to great investors is the ability to discern the secular from the cyclical, explains Richard Moroney, editor of Dow Theory Forecasts.
The best investors possess certain characteristics:
- An ability to sense when the herd is wrong and when it pays to be contrarian.
- A willingness to admit a mistake quickly and move on.
- The right amount of patience for an investment idea to work.
- Discipline to follow a strategy, even if it’s not working right now.
- An emotional detachment from the investment process.
Secular trends are long-term, structural changes that can have a profound impact on industries and companies. Secular trends tend to be driven by technological innovations, demographics, or government policy and regulatory changes. For example, retail has witnessed a massive secular shift in the last two decades as technological innovation and expanded delivery and shipping infrastructures have driven growth in e-commerce — at the expense of brick-and-mortar retailers. Secular trends can also arise from persistent macroeconomic conditions. For example, the long downward trend in interest rates and inflation that began in the 1980s had massive macro impacts on financial assets. Investors who rode those massive secular tailwinds (and held during periodic cyclical countertrends) enjoyed big wealth gains.
In contrast, cyclical trends are shorter-term fluctuations influenced primarily by the business cycle. Such boom-or-bust periods tend to have a much shorter shelf life than secular trends. While it is easy in hindsight to differentiate between secular and cyclical trends, the task is far more difficult in real time. Is the pullback in the stock market, sector, or individual stock merely a cyclical trend or something deeper and more dangerous? Is a company’s earnings disappointment a signal of a secular trend shift or merely a function of a downturn in the business cycle? Are the spikes in interest rates and inflation the beginning of a new secular trend or merely cyclical byproducts of one-off government intervention due to the pandemic?
The value trap Confusing cyclical for secular can be particularly harmful when it comes to value traps. Value traps occur when a stock looks cheap relative to peers or historical norms — but really isn’t cheap because something has changed. Especially dangerous are growth stocks transitioning to value stocks, which investors often view as opportunities: “I can finally buy that growth stock at value prices.” Underlying the enthusiasm is the assumption that the transition is cyclical, that the newly-minted value stock will revert to a growth stock again and trade at much higher prices.
Of course, such transitions can also spring from secular shifts, making the transition from growth to value not an opportunity but a trap, the beginning of a downward spiral. Ironically, some of today’s biggest questions in this secular versus cyclical debate surround the major drivers of secular change in the economy and industry. For example, Alphabet (GOOGL) has fallen 40% from its all-time high of a split-adjusted $151.55 in February 2022. To be sure, lots of technology companies have fallen sharply from their all-time highs. Nevertheless, thoughtful investors should ask themselves whether the company’s business model and its 90%-plus market share in search are sustainable in the face of potentially secular technological change.
In short, does Alphabet, which is transitioning from growth stock to value stock, face secular headwinds that will drive these shares lower over time. Is Alphabet a classic value trap? Or is the downturn in the company’s business and stock price merely cyclical? At this point, the Forecasts sides with the cyclical argument, believing Alphabet has the intellectual and financial firepower to rebound from its current position. Still, investors should consider the value-trap possibility as they view the weight of Alphabet (or any stock) in portfolios.
What questions should investors ask when considering whether a move in a sector or stock is secular or cyclical?
What Are the Salient Drivers of the Move?
Technological innovation, demographics, and regulations often key secular moves. Sensitivity to the business cycle is a strong tell for cyclical trends.
What is Happening to the Company’s Profit Margins?
Margins over a business cycle tend to offer important clues for deciphering secular versus cyclical changes. Companies benefiting from secular trends tend to have more consistent profit margins and outperformance relative to peers. A steady decline in profit margins, especially during up cycles in the economy, may reflect more serious, secular challenges. Perhaps the biggest bet in terms of secular versus cyclical involves the roughly four-decade period of falling interest rates and inflation. Are we reversing into a new secular trend of rising rates and inflation? The good news is that the Forecasts has a tool to help discern the secular from the cyclical when it comes to market trends: the Dow Theory. If, in fact, the spikes in inflation and interest rates represent secular risks, the market will likely reflect that via the action of the Dow Industrials and Transports.