Does History Repeat Itself? Business Cycle and Industry Returns

Abstract

Industries with higher historical business cycle regime Sharpe ratios have higher regime-dependent expected returns. Consequently, an out-of-sample sector rotation strategy generates 11.91% (14.02%) annualized alpha in Fama-French three-factor (five-factor) model during 1985--2014. This alpha isn't due to industry momentum, related anomalies, and less likely to be driven by standard risk-based explanations. Firms in long portfolios have stronger fundamentals, more upward analyst forecast revisions, and more positive forecast errors. Our results suggest that investors don't fully incorporate business cycle variation in cash flow growth and highlight the importance of business cycle on the cross-section of industry returns.

Keywords: Business Cycle, Industry Returns, Sector Rotation Strategy, Cash Flow News