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April 30, 2021, 1:06 p.m. EDT

How early is this business cycle, anyway?

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Andrea Riquier

There’s likely still room to run for stock market investors to employ cyclical themes, according to an analysis published Friday from Ned Davis Research, in large part because the “reopening trade” has reshaped the normal contours of the business cycle.

Still, the note argues, it’s important to keep an eye on what the different corners of the market are telling us about how far along in the cycle we are as the U.S. economy recovers from the coronavirus pandemic.

“One of our key themes in the second half of 2020 was that the reopening trade would unfold in phases,” wrote analysts Ed Clissold and Thanh Nguyen. “Unlike most bull markets, the typical early cycle leaders would not outperform at once, but in a staggered format depending on which aspects of the economy they needed to reopen.”

Indeed, while cyclical stocks outperformed immediately after the lows, they note, it wasn’t until the fourth quarter that small-caps popped higher, and for financials, it wasn’t until after the new year.

But more recently, the analysts note, some early-cycle names have underperformed. That’s in part because of the virus flare-ups in March this year, which prompted a return to trade in stocks that benefited from the “stay-at-home” trend last year.

Moreover, Clissold and Nguyen say, “since some early cycle themes started earlier than others, it stands to reason that the rotation could happen in phases.”

If that’s not the case,  the early part of the cycle might be over, meaning big market and earnings gains are in the rearview. “The second half of the year could be weaker than the first, as the market transitions out of the early cycle phase. In some cases, the transition can produce shallow cyclical bear markets.”

Related: Value stocks are so in favor they’ve become momentum stocks

Small-cap stocks took a while to outperform in 2020, but once they did, they “made up for lost time” in Q4 2020 and Q1 2021. Now, the analysts believe that the most bullish phase for small-caps /zigman2/quotes/208653303/composite IJR -0.83% is likely coming to an end.

In contrast, market sentiment has toggled between favoring Growth stocks /zigman2/quotes/208575548/composite QQQ +0.38% and Value /zigman2/quotes/209486178/composite VTV -0.01% , with Growth rallying since early March. Overall, Ned Davis models favor Value by the most in four years, but in the intermediate term, models favor Growth until a decisive breakout takes place.

Typically, companies that do not pay a dividend outperform those that do early in bull markets. This time, however, non-payers started outperforming almost immediately after the bear market low and are now well above their average gains. “Non-payers to payers could be one of the first early cycle to mid cycle rotations,” Clissold and Nguyen write.

Finally, Low Quality was one of the last early cycle themes to rally during this cycle. But since then, it too has slipped in recent weeks. “As a late bloomer this cycle, Low Quality could be a litmus test for whether the broader early cycle theme is merely pausing from is post-election surge or giving way to mid/late-cycle themes,” the analysts note.

Read next: What is factor investing?

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