The Business Cycle Theory of Thrift Savings Plan Investing

In its very simplest form, the business cycle (which is also often referred to as the economic cycle or stock market cycle) simply refers to alternating periods of simultaneous expansion in economic activities, followed by a similar contraction in the same activities. This sequence is repetitive, but is not periodic, meaning that a business cycle can last from a year to more than a decade.GDP growth chart - TSP Allocation Guide

Certain types of investments do better in different phases of the business cycle. If you can determine roughly where in the business cycle you are, it becomes a relatively simple matter to put your money into the investment type which performs best during that phase.

For my purposes, I divide the business cycle into four phases: Early (recovery/expansion), Mid (prosperity/growth), Late (slow down), and Recession. Many models use different names and attempt to divide the cycle into additional phases, or to subdivide the phases into different stages. But the Thrift Savings Plan is simple – you only really have three choice: the broad stock market (the TSP S Fund), large capitalization stocks (the TSP C Fund), and bonds (the TSP G or F Funds) – and so the simple model is all that we need for determining how to determine our Thrift Savings Plan allocation.

I will explain in more detail below, but in a nutshell I allocate my Thrift Savings Plan funds as follows during the different phases of the business cycle:

PHASE        THRIFT SAVINGS PLAN ALLOCATION

Early:           TSP S Fund

Mid:             TSP S Fund transitioning to TSP C Fund

Late:            TSP C Fund transitioning to TSP F Fund

Recession:   TSP F Fund transitioning to TSP G Fund

The Phases of the Economic Cycle:

The Early (Recovery/Expansion) Phase

Thrift Savings Plan Allocation: 100% TSP S Fund

This is the phase of the business cycle with the best performance. The broader stock market, which for us means the TSP S Fund which mirrors the Wilshire 4500 Completion Index, has produced a 24% average total return per year during this phase, and its average length has been a little more than a year (15 months). Some people will refer to the TSP S Fund as representing small capitalization stocks which is true only in a relative way because of the 4500 largest publicly traded US stocks, it represents those between places 1000 and 4500, with average value of around $1.25 billion.

This phase is characterized by rapidly improving growth, declining unemployment, low interest rates, low inflation, and improving public sentiment.

The Mid (Prosperity/Growth) Phase

Thrift Savings Plan Allocation: 100% TSP S Fund transitioning to 100% TSP C Fund. As the TSP C Fund’s monthly returns catch up to and overtake the returns of the S Fund, I will transition from 100% TSP S Fund, to 50% each TSP S Fund and TSP C Fund, and finally to 100% TSP C Fund.

This phase is typically by far the longest, averaging four years, and is characterized by strong growth, low unemployment, rising interest rates, increasing inflation, and strong public sentiment.

During this phase, economic activity is strong. Economic performance by all measurements is near its peak. Inflation starts to increase, so the Federal Reserve starts increasing interest rates in an effort to “cool down” the economy as it approaches full employment.

The Late (Slowdown) Phase

Thrift Savings Plan Allocation: 100% TSP C Fund transitioning to 50% each TSP C Fund and TSP F Fund. As leading economic indicators point towards an impending contraction I will move half of my funds to the safety of the TSP F Fund to protect them from a sudden drop, while maintaining the other half in the TSP C Fund to try to squeeze out the last of the growth in the business cycle.

If the Federal Reserve is successful in slowing the economy down, this phase is known as a “soft landing”. Ideally the economy would alternate between the growth and slowdown phases. But that usually is not what happens.

The slowdown phase has tended to last a year and a half on average, and even though things are slowing, overall stock market performance has averaged 9% on an annualized basis.

This phase is characterized by slowing growth, flat unemployment, flat interest rates, slowing inflation and increasingly negative public sentiment.

The Contraction/Recession Phase

Thrift Savings Plan Allocation: 100% TSP F Fund when interest rates are flat or falling, 100% TSP G Fund as interest rates begin to rise

If the Federal Reserve overshoots its intended soft landing, the recessionary phase or “hard landing” results. Growth is contracting, inflation tends to be lower, retail sales are weak and inventory levels are high. Corporations reduce their capacity by cutting down on workers, creating an overall higher level of unemployment. The central bank reacts by cutting interest rates.

This phase has historically been the shortest, lasting a little less than a year on average, and the broader market has performed poorly during this phase (-14% average annual return).

It is characterized by weak growth, high unemployment, falling interest rates and negative public sentiment.

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In my next post (How to Determine the Current Phase of the Business Cycle) I will explain how I establish where in the business cycle the US economy is currently located through a combination of economic indicators, and what the tipping points are for changing my Thrift Savings Plan allocation.

 

 

5 thoughts on “The Business Cycle Theory of Thrift Savings Plan Investing”

  1. Do you consider any allocation of the I fund? I know it’s not part of the US business cycle, but it does seem to have a place in investing…

    1. [email protected] says:

      Hi Skyler. Thanks very much for reading and your question. My view of the I Fund is on the short list of future blog posts I plan to write. The short answer is that sometimes the I Fund will definitely see some of my TSP funds allocated to it, but I am not in it right now. The I Fund tracks the MSCI EAFE Index which is a market cap weighted index which excludes the developing world. European markets comprise about 70% of the index followed by Japanese markets at 22%, and the rest of Asia-Pacific markets at only 8%. Europe is still groping around trying to put together a recovery but has not shown any ability to get traction. Japanese markets have recently had a good run run up (which I believe accounts for the I Funds performance over the past 12 months), but have otherwise been stagnant for the past twenty years. I do have some international exposure in my non-TSP holdings, but focused more on emerging markets. That’s about half a blog post right there, so maybe I will get that up sooner rather than later…

      1. [email protected] says:

        And in fact I did get a full post up on that subject at: http://www.tspallocation.com/tsp-i-fund-in-tsp-allocation-strategy/

  2. Thank you very much for making this great information available to all TSP investors. I like your TSP allocation.strategy because it is based on business cycle theory and is very easy to implement but łess risky than a buy and hold 100% stock funds forever strategy. Has anyone back tested your strategy or calculated hypothetical performance returns since the TSP started to report daily share prices?

  3. Have you mapped the Business Cycle over the past few decades? If so, during what time periods has the economy been in the Prosperity/Growth phase?

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