Sell High-Beta Stocks. Buy Low-Volatility Stocks. It’s The Business Cycle

Summary

A sound investment strategy takes advantage of the economic environment.

The economic environment drives the relative performance of investments.

The business cycle tells which stocks should be in your portfolio: high-beta vs low volatility.

The main forces driving the business cycle

There are three main types of economic indicators: leading, coincident, and lagging. The lagging indicators are the most important ones for investors because they determine the length of the business cycle and the severity of the economic correction needed to bring them down so the economy can expand again.

Inflation, interest rates, and labor costs are the most important lagging indicators. A rise in inflation reduces consumers’ purchasing power. The rise in interest rates makes purchases of anything less affordable – housing and autos in particular. Rising labor costs hinder profitability. Consumers react to the rise in inflation and interest rates by cutting first the purchase of big-ticket items. This is also the time consumer confidence of the University of Michigan declines sharply.

The slowdown in housing and auto sales are the first developments reflecting the economy is downshifting. Such slowdowns are reflected in equity prices. Coincident indicators such as employment and sales eventually also begin to sputter.

The investment opportunity in equities takes place when the leading indicators – those which were the first to signal the slowdown – are going to rise again.

One of the most important tenets of the business cycle is the slowdown will continue until the causes that created the slowdown are brought under control.

The main causes of the slowdown are the rise in the main lagging indicators: inflation and interest rates. The slowdown will continue as consumers reduce spending until their purchasing power restored again. This happens when inflation and interest rates decline. This is also the time when labor costs decrease, improving business profitability.

As retail sales increase because of rising consumers’ purchasing power, the other coincident indicators also rise: employment, production, and income. These developments will reinforce themselves and the positive loop will continue until the economy overheats.

This is the time when the lagging indicators raise their ugly heads, and the business cycle starts all over again.

Where are we now?

The lagging indicators are rising. Consumer prices keep moving higher – up more than 8%. Interest rates – short-term and long-term – have reached new highs for this business cycle. The two-year Treasury yield soared from 0.2% to 2.6% in the last 12 months. The stock market, an important leading indicator, shows no gains since June 2021 as of this writing. Auto sales and housing have been weakening after several months of rising inflation and interest rates.

Consumers cut spending on big-ticket items first when income after inflation declines as it is happening now (see graphs of buying conditions from University of Michigan survey below). In other words, an increase in the lagging indicators (inflation and interest rates) lead a peak in the leading indicator consumers’ buying conditions (see above chart).

The business cycle is just past Point 7 (see first chart above). The next trends will be slower growth in the coincident indicators. Retail sales and income after inflation are already contracting. Production and employment are still strong. They will have to weaken to reflect cuts in production to reduce inventories.

Inflation and interest rates will decline following more weakness in the coincident indicators (sales, income, production, and employment). In the meantime, growth in business activity will continue to decline until inflation and interest rates drop enough to increase consumers’ purchasing power. It will be a long and drawn-out process.

Economic growth drives sectors’ performance

The environment faced by the financial markets is slower economic growth. This is an important trend because the sectors outperforming the market when the business cycle declines, reflecting slower economic growth, are the non-cyclical sectors (XLP, XLU, XLV, XLRE) ( see chart below, energy being the exception).

The chart shows the percent change over the last 200 days. During a period of stronger growth cyclical stocks (XLI, IYT, XLF, XLE, XLB, XME) outperform the market. The strong performance of the non-cyclical sectors confirms the stock market is past its phase of fast growth.

High-beta and low volatility stocks respond to economic forces

High-beta (ETF: SPHB) and low-volatility stocks (ETF: SPLV) perform in different ways depending on the trend of the business cycle as shown on the following chart.

The above chart shows two sets of graphs. The upper panel represents the graph of the ratio SPHB/SPLV. The busines cycle indicator computed in real-time from market data and reviewed in each issue of The Peter Dag Portfolio Strategy and Management is in the lower panel.

High-beta stocks (SPHB) outperform low-volatility stocks (SPLV) (the ratio in the uppere panel rises) when the business cycle rises, reflecting stronger economic growth due to declining or stable inflation and interest rates.

However, low-volatility stocks (SPLV) outperform high-beta stocks (the ratio in the upper panel declines) when the business declines because of rising inflation and interest rates – as it has been happening since late 2021.

Key takeaways

  • The leading indicators will continue to decline reflecting rising inflation and interest rates.
  • During such time low volatility stocks (SPLV) will continue to outperform high-beta stocks (SPHB).
  • The leading indicators, such as stock prices, autos, housing, consumer sentiment of the University of Michigan, will bottom and rise again following a decline in inflation and interest rates.
  • The decline in inflation and interest rates will be preceded by declines in the coincident indicators (sales and income after inflation, production, and employment).
  • This will be the time when high-beta stocks (SPHB) start outperforming low-volatility stocks (SPLV).

China’s Weak Equity Market Reflects Poor Economic Performance. It’s The Business Cycle.

  • China is run by an autocratic political system.
  • China has shown disappointing economic growth.
  • China’s stock market reflects a system that is stifling growth and profitability.

In the article published 11/20/2020 (here) I wrote about the global business cycle, how business cycles and stock markets of the major countries are related among themselves, and how the US market responds to the changing global developments.

This article follows the same structure of the article mentioned above and updates the data reviewed at that time.

The global business cycles are perfectly synchronized

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The above graph shows the leading indicator of the global business cycle as published monthly by the Organization for Economic Co-operation and Development (OECD). The arrows show the peaks and troughs of the global business cycle. The dates of these turning points are important because they will be used later.

Since 2008 the global economy experienced four business cycles: 2009-2013, 2013-2016, 2016-2020, and the current one started in 2020. The most recent global business cycle peaked in 2021 and has been in a steady decline at least since November 2021. Global growth has been declining and is likely to decline further given the leading feature of the indicator.

The global leading indicator of the OECD is also related to the business cycles of the advanced economies.

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The above graph shows Germany’s business cycle. Note how the turning points coincide with those of the global business cycle.

Japan’s business cycle, with a different political structure, culture, and language than Germany’s has exactly the same turning points of Germany and of the global business cycle.

China’s business cycle

The above chart shows the performance of the general manufacturing PMI as released monthly by Caixin/Markit. The performance has been dismal at best when compared to that of other countries. Their PMI index is well below 50 when other countries are above 50, displaying growth.

The point is China’s economy, according to this indicator, has been stagnant for several years.

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China’s leading indicator published by the OECD maintains the same turning points as other countries. The only difference is China’s gauge shows much slower growth since 2010 and is now at a level reflecting a struggling economy.

The US business cycle

The above leading indicator of the US shows the same patterns and same dates of the turning points as for other countries. What needs to be noted is the only difference between the global business cycles is their amplitude which reflects different growth rates due to different economic policies.

While the OECD business cycles are derived from economic data collected from each single country, the above graph shows the US business cycle computed every second by The Peter Dag Portfolio Strategy and Management from market data from the NYSE.

Note how the turning points coincide with those of the global economy, Germany, Japan, and China and of many other countries not shown here.

This synchronicity of the global economies is simply astounding and shows how closely the global economies are connected despite the different cultures, and political systems. All these differences are captured in real-time by the internal market data of the NYSE and represented by the business cycle indicator which is reviewed in each issue of The Peter Dag Portfolio Strategy and Management.

This feature helps to recognize the direction of the global business cycle and the performance of global equity markets and that of China in particular.

China’s equity market

The graph in the above panel shows the performance of the Chinese market (GXC) since 2007. The lower panel shows the ratio GXC/SPY. GXC outperforms SPY when the ratio rises. GXC underperforms SPY when the ratio declines.

The Chinese market is below the levels of 2007. It has also underperformed the US market since 2010 (see lower panel).

The action of the Chinese market shows some important features.

  1. The Chinese market has struggled since the financial crisis of 2008, and it is now below the 2007 peak. This poor performance is consistent with the disappointing Chinese economic performance.
  2. The peak of each rally coincides with the peak of the business cycles of 2011, 2015, 2018, and 2021.
  3. The Chinese market has fallen sharply below its 200-dma in response to renewed economic weakness.
  4. The Chinese market has underperformed the US market, reflecting the superior performance of the US economy as reflected by the decline of the ratio GXC/SPY since 2010.

This cyclical performance of the Chinese market is not unique.

The above chart shows the performance of the German equity market (EWG). The lower panel shows the ratio EWG/SPY. The German market outperforms the US market when the ratio rises. The German market underperforms the US market when the ratio declines (see lower panel).

What has been said about China applies to the German market

1. The German market has struggled since the crisis of 2008, and it is now close to the 2007 peak.

2. The peak of each rally coincides with the peak of the business cycles of 2011, 2015, 2018, and 2021,

3.The German market is sagging below its 200-dma in response to renewed economic weakness.

4. The German market has underperformed the US market, reflecting the superior performance of the US economy.

Many other equity markets show the same features, and they are reviewed in each issue of The Peter Dag Portfolio Strategy and Management with their buy/sell signals. The point is the global equity markets, and the global business cycle are perfectly synchronized.

Key takeaways

  1. The turning points of the business cycle of the major economies take place at the same time.
  2. The turning points of the global business cycle coincide with the turning points of the business cycle indicator computed in real time from the NYSE market data and reviewed in The Peter Dag portfolio Strategy and Management.
  3. The global equity markets have the same turning points which coincide with the turning points of the business cycle.
  4. China’s equity market follows the pattern of other foreign equity markets.
  5. China’s equity market has been performing poorly since 2007, reflecting poor economic conditions. It is likely to continue to show disappointing performance given the weakness and downtrend of the US and global business cycle.
  6. Rising commodities, inflation, interest rates, and declining purchasing power will force the Chinese and other equity markets to decline.
  7. Chinese and other major equity market will rise following a decline in commodities, inflation, and interest rates.

For a look at all of today’s economic events, check out our economic calendar.

Bank Stocks Will Keep Underperforming. It’s The Business Cycle.

Summary

Bank stocks are sensitive to interest rates.

Interest rates are sensitive to the strength of the business cycle.

The attractiveness of bank stocks depends on the trend of the business cycle. Not interest rates.

My article of January 2021 concluded:

“…… rising yields at the beginning of a business cycle is good news for bank stocks. Yields rising to levels damaging the economy and causing the business cycle to decline is bad news for the banking sector.”

To recognize what is happening now it is useful to review how the banking sector responds to changes in the business cycle.

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Source: The Peter Dag Portfolio Strategy and Management

Business Cycle and Its Phases

The business cycle goes through four distinctive phases. The trends pointing to the end of Phase 4 are:

  • Commodity and inflation are declining.
  • Sales growth is lower than the pace of inventory accumulation.
  • Income after inflation starts rising.
  • Consumer confidence rebounds as consumers respond favorably to the decline of inflation, interest rates, and to the rise of real income.

These favorable developments create the conditions for the business cycle to move into Phase 1. Sales increase because of consumers’ improved financial conditions. Business is forced to boost production to build up inventories to respond to the rising demand. Business will have to hire new people, buy raw materials, and increase borrowing to improve and possibly expand capacity.

These activities place a floor on commodities and interest rates. As the positive feedback continues, improved sales feed into rising inventories, rising employment, and increased borrowing.

This expansion benefits the banking sector, of course, because it provides the liquidity needed to fuel the positive loop thus creating even more growth. This is the time when bank stocks outperform the market.

There is a point, however, when the high level of production places upward pressure on commodities, interest rates, and inflation. The business cycle enters Phase 2, reflecting an even stronger economy.

But rising commodities, interest rates, and inflation eventually have a negative impact on the finances of consumers as it is happening now. Consumer confidence peaks and then declines. Demand for goods slows down.

Business recognizes inventories are now rising too rapidly due to the slower demand and are having a negative impact on earnings. Production is curtailed. Purchases of raw materials are reduced. Hiring is cut. Improvements and expansions of capacity are delayed resulting in lower borrowing, an unwelcome development for banks.

What Phase Are We in Now?

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Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the business cycle indicator updated in real time from market data and reviewed in each issue of The Peter Dag Portfolio Strategy and Management. It shows the previous two cycles (2011-2014 and 2014-2020) and the current one started in 2020.

This indicator and data about growth in heavy truck sales, in income after inflation, in retail sales after inflation, and the action of the defensive market sectors (see below) confirm the business cycle is now declining, reflecting slower economic growth. The business cycle is now in Phase 3.

The slowdown process will continue until the causes that produced it are brought under control and consumers recognizes their finances are improving. This new environment will be characterized by the decline in inflation and interest rates. This process will take place in Phase 4, the most painful phase for consumers and the financial markets.

During Phase 3 and Phase 4 the sectors outperforming the markets are utilities (XLU), healthcare (XLV), staples (XLP), REITs, and long duration Treasury bonds.

The performance of the various sectors keeps repeating as the business cycle swings from periods of stronger to weaker growth.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The sectors outperforming the market over the last two hundred days (except for energy) have been the four sectors mentioned above. Their performance confirms the business cycle is declining, reflecting a weakening economy.

The financial sector, and banks in particular, is a cyclical sector outperforming the market during periods of strengthening business cycle.

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Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the ratio of Invesco KBWB bank ETF and the S&P 500 ETF (ratio KBWB/SPY). The ratio rises when bank stocks outperform the market. The ratio declines when bank stocks underperform the market.

The lower panel of the above chart shows the business cycle indicator computed in real-time as reviewed in each issue of The Peter Dag Portfolio Strategy and Management.

The chart shows bank stocks outperform the market (the ratio rises) when the business cycle rises, reflecting a strengthening economy. The ratio declines, reflecting the underperformance of the bank stocks, when the business cycle indicator declines in response to a weakening economy. Chart, histogram Description automatically generated

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows regional banks stocks (ETF: KRE) respond like the major center banks stocks to the changes of the business cycle. They outperform the market when the business cycle indicator rises and underperform the market when the business cycle indicator declines. Chart, histogram Description automatically generated

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Even large and well managed banks like JP Morgan (JPM) are not immune to the changes in the business cycle as shown in the above chart. The stock of JP Morgan outperforms the market when the business cycle rises and underperforms the market when the business cycle declines.

Key Takeaways

  1. Bank stocks respond to changes of the business cycle and not of interest rates.
  2. Bank stocks outperform the market when the business cycle rises, reflecting a strengthening economy (Phase 1 and Phase 2 of the business cycle).
  3. There is a point when rising interest rates and inflation cause the business cycle to decline. This is the time when bank stocks start underperforming (Phase 3 and Phase 4 of the business cycle).

Sell Crude Oil, Soybeans, And Copper

  • As in the 1970s, we face an energy crisis.
  • The outcome is soaring crude oil prices.
  • Now, as then, crude oil is spiking.
  • Why are then soybeans and copper prices acting the same as crude oil?

Commodities traded in a broad range for many years. Sometimes decades. An economic crisis eventually pushes them to trade around much higher levels. I am going to show the price trends of three commodities seemingly unrelated. Wall Street suggests mainly cartels and wars drive crude oil prices. The weather is the main reason for the price changes of agriculturals. Copper prices are driven mostly by the demand by housing and industrial applications.

Let’s see what the charts are saying

Let’s look at the first chart – crude oil. From 1982 to 2004, for more than 20 years crude oil traded between $15 and $30. In 2004 the price jumped and started trading in a new range from $40 to the recent $119 levels.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The second chart shows the price of copper. This commodity also traded in a range for more than 20 years from 1981 to 2004. In 2004 the price of copper surged and since 2006 it has been trading in the $2.00-$4.50 range.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The chart of soybeans shows a surprising resemblance to the graphs of the previous two commodities. From 1981 to 2006 soybeans traded in the $500-$900 range – a 25-year span. In 2007 soybeans spiked to above $1500 and traded in a broad range since then.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above figure shows the graphs of the three commodities on the same chart – crude oil (red), copper (lime) and soybeans (black). They follow closely each other.

The major turning points of the graphs seem to coincide. This begs the question of how reliable is Wall Street’s view of the trend of, say, soybeans and the trend of crude oil. One is based on various weather forecasts, dryness of the land, temperature ranges, and other atmospheric parameters.

The price of crude oil, on the other hand, is highly discussed at all levels of government as caused by wars, cartels production strategies, and oil company objective to maximize profits. Yet, the two commodities follow closely the same price pattern.

Subjects like growth in the money supply was followed closely in the 1970s as Milton Friedman convinced us about the importance of the growth of money on inflation and economic growth. Since 1983 inflation and economic issues were not a major concern, so the subject has not been followed.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

The reason inflationary pressures are being felt by all commodities is that since 2005 money supply growth exploded well above its historical norm of 4%-6% to cushion a financial crisis, provide economic stimulus and social programs.

Commodities surged to a new trading range and inflation eventually exploded because of the continued money printing of the Fed to finance government programs after 2020 with growth rates close to 25% y/y. The outcome has been continued volatility in commodities, equities, and soaring inflation.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

From a near-term perspective the above chart sheds some light.

Spikes in commodity prices happen following a period of strong growth as reflected by the rising real-time business cycle indicator (lower panel) which is updated using market data in each issue of The Peter Dag Portfolio Strategy and Management. (No available market data were available prior to 2004 to compute the business cycle indicator).

Furthermore, the rate of change of oil and the other commodities has soared to levels associated with a top in crude oil (middle panel of above chart).

Source: University of Michigan

Rising inflation reduces real income (personal income is now down -9.7% y/y) and has a negative impact on consumer sentiment and demand. The outcome is the business cycle indicator declines. This is the time the above commodities decline. This is what is happening right now.

Unfortunately, the current level of consumer pessimism is one of the lowest in over sixty years and has been invariably followed by a recession (see above chart). The anticipated decline in the commodity complex reflects the incoming period of very low growth caused by weaker demand due to sagging income after inflation.

Key takeaways

  • Surges in money supply well above 4%-6% – usually caused to accommodate government programs, wars, or financial crises as in the 1970s, 2000, and after 2020 – cause sharp increases in commodities and inflation.
  • The effect of excessive growth of the money supply impacts the fundamental trend of most commodities irrespective of the action by cartels, weather patterns, or housing trends.
  • The current business climate is characterized by excessive inventory growth (14.7% y/y at the wholesalers’ level) when the average growth is close to 4%-5%.
  • Inventories will be corrected to adapt to slower demand caused by declining personal income after inflation (down -9.7% y/y).
  • The decline in inventories will be achieved by reducing production and purchases of raw materials, employment, and borrowing needs. This process will place downward pressure on crude oil and other commodities.

United States Steel (X) Underperforms The Market In A Weaker Economy

  • US Steel’s price pattern is closely related to the business cycle.
  • US Steel underperforms the market when business slows down.
  • US Steel will continue to underperform the market.

It operates through three segments: North American Flat-Rolled (Flat-Rolled), U. S. Steel Europe (USSE), and Tubular Products (Tubular).

The Flat-Rolled segment offers slabs, strip mill plates, sheets and tin mill products, as well as all iron ore and coke. This segment serves customers in the service center, conversion, automotive, construction, container, and appliance and electrical markets.

The USSE segment provides slabs, strip mill plate, sheet, tin mill products, and spiral welded pipes, as well as refractory ceramic materials. This segment serves customers in the construction, container, appliance and electrical, service center, conversion, oil, gas, and petrochemical markets.

The Tubular segment offers seamless and electric resistance welded steel casing and tubing products, as well as standard and line pipe and mechanical tubing products primarily to customers in the oil, gas, and petrochemical markets. The company also provides railroad services and real estate operations.

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Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The stock of US Steel shows a well-defined downtrend channel since 2007. The price behavior also shows considerable volatility. This volatility is not a random event. It represents the expectations of US Steel’s performance caused by changes in the business cycle.

The inventory cycle is helpful to explain why the price of US Steel responds to the business cycle.

Source: Profiting in Bull or Bear Markets – How Business Cycles Impact The Financial Markets

Business managers must filter all the news coming from different sources such as pandemics, cartels, supply chain difficulties, foreign or domestic supplier availability, trends in commodities and interest rates, changes in value of the dollar, and the Fed. Eventually they must make a crucial decision: how much to produce to replenish the inventories at levels needed to meet the demand for their goods.

The business cycle transitions through four phases as management changes its inventory policies. In Phase 1 and Phase 2 business decides to build inventories to meet growing demand. This decision results in increases in the purchase of raw materials, hiring more people, increase in borrowing to finance operations and improve and expand capacity.

This is the time the business cycle grows through Phase 1 and Phase 2. This is also the time commodities, copper, iron ore, other metals, crude oil, lumber, agriculturals, interest rates, and inflation rise. The increase in these prices is a testimonial the economy is strengthening.

The problem arises toward the end of Phase 3. The continued rise in commodities, copper, iron ore, other metals, crude oil, lumber, agriculturals, and in overall inflation eventually reduces consumers’ purchasing power in a meaningful way. The consumers’ response is a slowdown in spending.

The outcome is in Phase 3 managers begin to experience rising inventories compared to sales with a direct impact on their financial performance. The need to reduce inventories involves cuts in the purchase of raw materials, reduction in the workforce, and declines in borrowing. This process continues until inventories are in line with demand. The inventory to sales ratio keeps rising during these times as inventories rise faster than sales. During Phase 3 and Phase 4, because of the action of business, commodities, including iron and most metals, decline, wages slow down, and interest rates decline.

When inventories are finally adjusted to the desired level, matching their growth with the growth of demand, the business cycle transitions from Phase 4 to Phase 1. At this point the inventory to sales ratio starts declining again. It reflects sales rising faster than inventories. Business will have to increase production to restock inventories. And the business cycle moves to Phase 1. The markets will respond promptly.

X acts positively to the forces driving the price of iron ore and other metals and labor costs when business is in the process of building up inventories (Phase 1 and Phase 2). This is the time price increases are likely to hold.

However, when the business cycle transitions into Phase 3 and Phase 4, demand for steel-based products such as autos declines, and profitability suffers. The price of the stock weakens reflecting these adverse times.

Sources: StockCharts.com, The Peter Dag Portfolio Strategy and Management

When does the price of US Steel outperforms the market? The above chart gives us the answer.

The above chart shows two panels. The graphs in the above panel represent the ratio between X and SPY. The second graph is its 200-day moving average. The graphs rise when X outperforms SPY. The graphs decline when X under-performs SPY. Investors are going to outperform the market if they invest in X when the graphs rise. The graph also indicates X has underperformed the market at least since 2007.

The bottom panel shows the business cycle indicator, a proprietary gauge updated regularly in The Peter Dag Portfolio Strategy and Management. This indicator is computed in real-time from market data. Its turning points coincide also with the cyclical turning points of the growth of employment in manufacturing and credit spreads.

The relation of X to the business cycle is quite telling. X outperforms the market when the business cycle rises, reflecting stronger economic growth and rising commodity prices. The ratio X /SPY declines, reflecting the underperformance of X relative to SPY, when the business cycle declines, reflecting slower economic growth and lower commodity prices.

The recent weakness in the business cycle indicator suggests X will continue to underperform SPY (the ratio will keep declining).

Key takeaways

  • The business cycle will decline, reflecting slower economic growth. The slowdown is mostly driven by rising inflation, causing the decline in demand due to the contraction in consumers’ disposable personal income after inflation.
  • X will continue to underperform SPY as long as the business cycle indicator declines.
  • The business cycle indicator will rise following a decline of inflation. Growth in M2 must fall from the current 13% to about 6%. Real disposable income will also rise accompanied by improving consumer sentiment (University of Michigan survey).
  • X will start outperforming the market at that time.

AZO Outperforms The Market In A Weaker Economy

AutoZone, Inc. retails and distributes automotive replacement parts and accessories. The company offers various products for cars, sport utility vehicles, vans, and light trucks, including new and remanufactured automotive hard parts, maintenance items, accessories, and non-automotive products. As of November 20, 2021, it operated 6,066 stores in the United States; 666 stores in Mexico; and 53 stores in Brazil. The company was founded in 1979 and is based in Memphis, Tennessee.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The performance of AZO’s stock confirms it has been a great investment. The issue is whether AZO is still attractive now as a strategic investment. Will AZO keep performing if the economy slows down as many analysts expect?

The price pattern of AZO compared to the S&P 500 is particularly telling when matched to its behavior during previous business cycles.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows two panels. The graphs in the above panel represent the ratio between AZO and SPY. The second graph is its 200-day moving average. The graphs rise when AZO outperforms SPY. The graphs decline when AZO under-performs SPY. Investors are going to outperform the market if they invest in AZO when the graphs rise.

The bottom panel shows the business cycle indicator, a proprietary gauge updated regularly in The Peter Dag Portfolio Strategy and Management. This indicator is computed in real-time from market data. Its turning points coincide also with the cyclical turning points of the growth of employment in manufacturing and credit spreads.

The relation of AZO to the business cycle is quite telling. AZO outperforms the market when the business cycle declines, reflecting slower economic growth. The above chart shows the ratio AZO/SPY rises, reflecting the outperformance of AZO relative to SPY, when the business cycle declines.

The recent weakness in the business cycle indicator suggests AZO will continue to outperform SPY (the ratio will keep rising).

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows AZO’s momentum indicator just bottomed, suggesting the ratio AZO/SPY is likely to rise and AZO to outperform SPY.

Key takeaways

  •  The business cycle will decline, reflecting slower economic growth. The slowdown is mostly driven by the decline in disposable personal income after inflation.
  • AZO will continue to outperform SPY as long as the business cycle indicator declines.
  • The business cycle indicator will rise when inflation declines. At that time real disposable income will also rise accompanied by improving consumer sentiment (University of Michigan survey).

The Fed Is In A Box

Summary

  • Wall Street is concerned about the impact of the Fed’s planned tapering.
  • However, rising inflation and labor costs will hinder economic growth.
  • Slower consumers’ spending and cutting costs by businesses will slow down the growth of the money supply M2.

The historical growth of the money supply M2 is closely related to the average growth of the economy before inflation.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

The above graph shows the growth of M2 in the 1960s was about 6%. In the 1970s the growth of M2 doubled, soaring to 13%. This growth was needed to finance massive government budget deficits required to fund a war and rising social welfare programs (see above chart). The outcome was steadily rising inflation. In 1980 inflation hit 15%.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

Beginning in early 1980 the growth of M2 started to decline to an average growth rate of about 5%-6% (see above chart).

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

As the growth of M2 declined close to its historical average, inflation also headed lower. Until 2019 the growth of consumer prices over 12 months has been about 2%-3% (see above chart), reflecting a much slower growth of M2.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

Beginning in 2020, because of the government’s many social programs to protect the economy from Covid-19, the growth of the money supply M2 was allowed to expand at the torrid pace of more than 25% over 12 months (see above chart).

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

In 2020 the strong growth of M2 was followed, as it did in the 1970s, by rising inflation. Home prices soared from below 5% y/y to above 20% y/y. Producer prices jumped from close to 0% y/y to more than 12% y/y. Consumer prices rose from 1.7% y/y to 6.2% (see above chart).

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

Inflation did not only show at the consumer level. Inflation is transmitted to businesses through rising input costs. It is no coincidence as inflation at the consumer level rose sharply, employment costs (wages and benefits) jumped from 1.9% y/y to 4.0% y/y (see above chart). Such an increase in costs is already placing downward pressure on business profitability.

Source: University of Michigan

Consumers are responding to the increase in inflation and the resulting loss of purchasing power. Consumer sentiment is plunging to levels seen during recessions (see above chart).

Where do we go from here?

M2 continues to grow at a strong pace (13.0% y/y) as the Fed keeps printing money to “finance” the government’s outlandish programs. Inflation keeps rising, further destroying consumers’ purchasing power.

Weakening demand will force manufacturing to cut inventories. Business activity will decline as the business brings inventories in line with sales. The economy will enter a recession as consumers reduce spending.

The stock market will face a bear market. The business slowdown will be accompanied by slower growth in M2 and lower inflation. Yields will decline to much lower levels below 1.0% as the Fed, like the ECB and the BOJ, watches the unraveling of an ill-advised monetary policy pegging short-term interest rates to 0%.

Key takeaways

The forces of the business cycle are unstoppable. For this reason, the Fed is in a box.

  1. The rise in inflation is reducing consumers’ purchasing power.
  2. The decline in purchasing power is reflected in slower sales.
  3. The business eventually cuts output to reduce costs as it faces slower sales and rising inventories.
  4. As business keeps downshifting, M2 growth declines from the current 13% to about 6%.
  5. Stock prices continue to perform poorly with capital gains from long-term Treasury bonds outperforming the S&P 500.
  6. Inflation declines is caused by slower sales, slower production, and much slower growth in M2.
  7. Consumer sentiment improves.
  8. At that time the market resumes its bullish trend with cyclical stocks outperforming defensive stocks and bonds.

Consumers Will Cause A Recession And A Bear Market

Summary

  • Analysts expect continued growth in earnings.
  • However, inflation is rapidly eroding consumers’ purchasing power.
  • The decline in demand will cause business to become defensive.

In a recent release of the Atlanta Fed, their model measured GDP growth in Q3 of 0.5%, down from 33.8% in Q3 2020. The decline has been relentless but unnoticed given the amount of liquidity thrown by the Fed to the problem.

Source: Atlanta Fed

The issue is – where do we go from here? Can the US economy strengthen and grow at a faster pace?

The answer is in the hands of consumers since they are 70% of the economy. Consumers’ sentiment is closely tied to the business cycle and its leading, coincident, and lagging indicators.

The behavior of the consumer is measured by the survey of the University of Michigan. The most popular is the survey of consumer sentiment shown below.

Source: University of Michigan

As you can see from the above chart, consumer sentiment is a reliable leading indicator of recessions (shaded areas). Peaks in consumer sentiment have invariably led poor business activity or recessions.

How can we use the relationship between leading, coincident, and lagging indicators to predict turning points in consumer confidence and in the economy?

Source: Profiting in Bull or Bear Markets, The Peter Dag Portfolio Strategy and Management
Source: Profiting in Bull or Bear Markets, The Peter Dag Portfolio Strategy and Management

The important, and mostly overlooked, lagging indicator provides the answer. The graphs show an increase in the lagging indicators (inflation, interest rates, change in home prices) is followed by a peak in the leading indicators (consumer sentiment). The reason is rising inflation and home prices severely hinder consumers’ purchasing power.

The outcome is lower spending for goods and services (all coincident indicators). Because of weaker consumer spending, the economy slows down and may even contract.

When will consumers start to increase spending again, thus stimulating the growth of the economy? The answer is when consumers’ purchasing power increases because of declining inflation, interest rates, and home prices.

The lagging indicators have a crucial role in determining the length of the business cycle. They usually rise after one-to-two years following the beginning of an expansion. The sooner they rise, the shorter the duration of the business cycle will be because of the negative impact on the purchasing plans of the consumers.

Source: St. Louis Fed

Inflation is still rising at a rapid clip (see above chart). Home prices are up +19.7%. Producer prices soared +11.8%. Consumer prices jumped +5.4%. Rising inflation has sharply reduced consumers’ real disposable personal income which has declined in four of the last five months.

These trends suggest business activity cannot improve unless inflation, interest rates, and home prices decline enough to improve consumers’ sentiment and their purchasing power. Or, to put it in another way, the current economic slowdown will continue until there is a visible decline in the lagging indicators. Only then will the economy resume to grow at a faster pace.

Stock prices are also an important leading indicator of the economy, and their trend is in fact closely related to consumer sentiment as shown in the chart below.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Important takeaways

  • Consumer sentiment has declined sharply because of the loss of consumers’ purchasing power caused by rising inflation, interest rates, and home prices.
  • The economy has displayed a sharp deceleration since 2020 despite the engineered generous stimulus programs of the government.
  • The decline in consumer sentiment will have a negative effect on the economy, earnings, and stocks.
  • Consumer sentiment will improve after a visible decline in inflation, interest rates, and home prices. Until then, business activity and equity prices will struggle.
  • There is nothing the Fed can do about what is likely to happen. They can only make matters worse by encouraging higher short-term interest rates.

No Upside For Cyclicals, Commodities, And Yields. It’s The Business Cycle.

Summary

  • The business cycle drives markets.
  • The business cycle is at a turning point.
  • The decline of the business cycle drives earnings, yields, and commodities lower.
  • The business cycle will rise again when inflation and home prices decline.
Source: The Peter Dag Portfolio Strategy and Management

The decision to increase production to replenish inventories due to increasing demand involves several steps. There is the need to hire more people, to increase the purchase of raw materials, and to increase borrowing to finance operations and to improve and increase capacity.

These decisions have a positive impact on employment and income. Commodities find a bottom following the prolonged slide during Phase 3 and Phase 4. Yields also stabilize as the demand for credit increases.

The positive feedback is caused by rising employment, rising income, and rising sales. Business needs to increase production to replenish inventories to meet expanding demand.

There is a point, however, when capacity constraints begin to appear, and the economy is overheating. The business cycle is now in Phase 2. In this phase commodities rise first, followed by rising yields. Wages grow faster and inflation moves higher.

This is where we are now. Inflation is beginning to erode the purchasing power of the consumers. Home prices have been rising fast, impacting consumers’ optimism. The outcome is a slowdown in retail sales.

This is a critical phase for business. Cutting production to adjust inventories due to the prospect of slower sales is not an easy decision. The costs involved in reducing capacity are high. However, industrial production eventually must be cut to adjust inventories to waning demand.

This is the time when the business cycle enters in Phase 3. The slowdown in production shows at first in lower growth in average workweek, lower commodities and lower yields.

The negative feedback of lower employment, lower demand, lower inventories, lower production, lower income will eventually stop in Phase 4. The end of this phase will be flagged by the decline of the main factor that has caused consumers to reduce their purchases.

As soon as inflation declines, purchasing power improves, demand rises, and the positive feedback causes the business cycle to enter in Phase 1.

Where do we stand now?

 Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Inflation is rising with consumer prices up more than 6% y/y (see above chart). Inflation has been steadily rising since 2016, an event clearly noticed by consumers.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Consumer sentiment rose more slowly beginning in 2016 as inflation started to rise. The sharp rise of inflation since 2020 has been accompanied by steeply lower consumer optimism. Overall inflation is hurting the purchasing power.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and ManagementInflation at the gas pump, groceries, and retail stores is not the only enemy of consumers’ optimism. The increase in home prices of more than 15% y/y is creating a negative environment for spending (see above chart). One more reason why consumer confidence has declined sharply in the past several months.

 Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

It should come as no surprise, therefore, that retail sales have been growing more slowly, declining in three of the past six months (see above chart). It seems reasonable to expect consumer confidence to improve only after inflation and home prices start slowing down, thus increasing the purchasing power of consumers.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and ManagementThe job of business is to produce and stock the products consumers want to buy. This is what has happened since 2020 (see above chart). Inventories have been growing rapidly since April and the rate of change is still rising. Business will have to cut inventories considering declining consumer confidence and slower sales.

This is exactly the inflection point pushing the business cycle from Phase 2 to Phase 3. Like many times in the past, business will eventually be forced to slow down production as consumers’ demand keeps slowing down. This is where we are now in the business cycle.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The business cycle indicator in the above chart shows the business cycle is declining, reflecting a slowdown in business activity. The slowdown is meaningful enough to be accompanied by lower copper (and commodities in general) and yields.

This is what investors should expect when the business cycle is in Phase 3. The business cycle indicator is updated in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary subscription is available to the readers of this article on www.peterdag.com.

Key Takeaways

  • The business cycle is in Phase 3 and will eventually transition to Phase 4.
  • Inflation will decline toward the end of Phase 4.
  • Cyclical stocks are unattractive in Phase 3 and Phase 4.
  • Defensive stocks and bonds outperform the market in Phase 3 and Phase 4 as discussed in a previous article (see here).
  • Inflation is rising with consumer prices up more than 6%
  • The decline in both inflation and the growth of home prices will trigger the end of the weakness in cyclical stocks. Defensive stocks and bonds will start underperforming at that time.

JPM, BAC, Financials – Unattractive.

Utilities (XLU), staples (XLU), healthcare (XLV), and real estate (XLRE) were the worst performers. These sectors perform well in the declining phases of the business cycle and underperform in the rising phases of the business cycle.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Financial stocks performed well because they outperform the market during the rising phase of the business cycle. The reason for this outperformance was the strengthening of the business cycle since March 2020. This important pattern was reviewed in my article “Bank Stocks, Interest Rates, And Business Cycles – Not That Obvious (March 25, 2021)”.

There have been important changes in the economy and in our business cycle indicator to suggest some adjustments to the outlook for financials and bank stocks.

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Source: The Peter Dag Portfolio Strategy and Management

The downturn of the business cycle (Phases 3 & 4) reflects a significant slowdown in business activity. This is the time when portfolios should avoid cyclical sectors and be overweight defensive sectors and bonds as I discussed in my article here.

The decline of the business cycle is anticipated by a rise in commodities and inflation. The reason is these trends undermine consumers’ purchasing power. The resulting slowdown in demand is not recognized at first by business which remains mainly focused on replenishing inventories. Production must be increased to meet sales growth.

Eventually, because of slowing demand, inventories start rising faster than sales. The decision must be made to reduce production to cut inventories.

The reduction in production requires a cut in working hours. The cut in working hours is followed by layoffs, reduction in purchases of raw materials and borrowing to finance operations.

The forces unleashed by the inventory correction are visible in slower growth in manufacturing employment, declines in commodity prices, and lower yields.

This transition from Phase 2 to Phase 3 has major strategic importance for investors. Stocks outperforming during the strong phase of the business cycle (such as industrials) start disappointing because of the uncertain outlook for their profits. The defensive sectors (such as utilities), on the other hand, begin to outperform as investors choose them for their reliable profitability.

The following chart reviews the performance of the financial stocks (XLF) with the updated version of our business cycle indicator.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management.The above chart shows the ratio of XLF (financials) and SPY (S&P 500). XLF outperforms SPY when the ratio rises. XLF underperforms SPY when the ratio declines. Investors should be overweight financial stocks when the ratio rises and be underweight financials when the ratio declines.

The lower panel of the chart shows the business cycle indicator, a proprietary indicator updated in each issue of The Peter Dag Portfolio Strategy and Management. The graphs show the best time to own financials is when the business cycle indicator rises, reflecting a strengthening economy.

The business cycle indicator has been declining, as discussed also in previous articles. A likely continuation of the declining of the business cycle indicator points to underperformance of the financial stocks.

The following chart shows how the banking sector, a subset of the financial sector, performs during a complete business cycle.

The above chart shows the ratio of KBWB and SPY. The Invesco KBW Bank ETF (KBWB) normally invests at least 90% of its total assets in companies primarily engaged in US banking activities. KBWB outperforms SPY when the ratio rises. KBWB underperforms SPY when the ratio declines.

The above graphs show KBWB performs like XLF during a business cycle. The time to be overweight in KBWB is when the business cycle indicator (lower panel) rises, reflecting a strengthening economy. Investors should be underweight bank stocks when the business cycle indicator declines, reflecting a weakening economy.

Do regional banks perform differently from financial and bank stocks?

Source: StockCharts.com, The Peter Dag Portfolio Strategy and ManagementThe upper panel of this chart shows the ratio of KRE (regional banks) and SPY. The chart shows regional banks become unattractive (the ratio declines) when the business cycle declines, reflecting a weakening economy.

Are large money-center banks immune to the forces of the business cycle?

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The ratio of JPM (JP Morgan) and SPY (upper panel) rises when the business cycle indicator (lower panel) rises, reflecting a strengthening economy. JPM underperforms SPY (the ratio declines) when the business cycle indicator declines, reflecting a weakening economy.

JPM, a major money center bank, is responding to changes of the business cycle like the overall financial stocks (XLF), bank stocks (KBWB), and regional bank stocks (KRE).

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Bank of America (BAC) is also a money-center bank responding to the business cycle. The upper panel shows the ratio of BAC and SPY. BAC is also outperforming the market (SPY) when the business cycle rises. It underperforms the market when the business cycle declines, reflecting a weakening economy.

Key takeaways

  • Because of sharply rising inflation the business cycle is transitioning from Phase 2 to Phase 3.
  • Financials and bank stocks will continue to underperform the market (SPY) as long as the business cycle indicator declines.
  • Financial stocks and bank stocks will start outperforming the market (SPY) when the business cycle transitions from Phase 4 to Phase 1. This transition will be anticipated by sharply lower inflation.
  • Long-duration Treasury bonds will continue to provide total returns outperforming the returns from SPY as long as the business cycle indicator declines, as discussed in previous articles.

Options Point To A Bear Market

Summary

  • Bonds outperform stocks during critical market declines.
  • The business cycle provides valuable information about these periods.
  • The options market is adding to the bearish signals for the market and the business cycle.

The business cycle is a powerful force investors should use to their advantage. It has been saying to be careful and to start adopting a defensive strategy.

Chart, pie chart

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Source: The Peter Dag Portfolio Strategy and Management

The previous business cycle started in 2016, peaked in 2018, and ended in March 2020. The current business cycle began violently in March 2020. Its force created strong dislocations, further exacerbated by several stimulus programs and easy monetary policy.

The outcome has been a rapid ramp-up in production to replenish depleted inventories. The business had to aggressively buy commodities to produce goods, hire workers and pay higher wages, and increase borrowing to finance operations and improve productive capacity.

It is no coincidence most commodities have been soaring – from soybeans to lumber to metals to crude oil. Bond yields also jumped, worrying Wall Street about soaring interest rates. Inflation rose and is still rising rapidly.

These are the type of developments experienced toward the end of Phase 2 (see above chart) and cause the business cycle to transition from Phase 2 to Phase 3 due to their negative feedback.

In fact, the increase in inflation and interest rates has a negative impact on consumers’ purchasing power. The weaker trends in home and auto sales – two major sectors of the economy – are already reflecting the negative consequences of rising inflation, interest rates, and home prices.

Business, however, is still busy replenishing inventories. It has not yet been recognized demand is gradually waning. Eventually, manufacturers will realize they overbuilt inventories when profits fail expectations. The decision will have to be made to reduce production, reduce the purchase of raw materials, and reduce borrowing. The business cycle is not yet at this point, but we are very close to this defining moment.

Since the main cause of most slowdowns is rising inflation and rising interest rates, the slowdown will end when the inflation and interest rates decline enough to re-establish the purchasing power of consumers.

The patterns of previous business cycles suggest the decline could last one to two years depending on the damage created by rising inflation and interest rates to consumers’ purchasing power.

Chart, line chart

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Source: StockCharts.com, The Peter Dag Portfolio Strategy and ManagementThe above chart is an updated version of the one discussed in previous articles. It shows an indicator derived from the option market (lower panel). The ratio of SPY divided by TLT is shown in the upper panel. A rising ratio means the returns from SPY are greater than those from TLT. A declining ratio means the returns from TLT are greater than those from SPY.

What makes this gauge particularly interesting is it has the same turning points of the business cycle indicator as discussed in the articles listed at the beginning.

The business cycles reflected by the option market are those of 2009-20012, 2012-2016, and 2016-2020. The most recent business cycle started in March 2020 and rose sharply until the beginning of 2021.

Growth, however, is slowing down and we are close to a peak in the business cycle. We are possibly already in Phase 3. This phase is recognized by weakness in commodities, a peak in bond yields, fluttering stock prices, and long-duration Treasury bonds outperforming the S&P 500.

The peak in the option market indicator confirms what we have been writing in the previous articles – total returns from long-dated Treasury bonds (TLT) will continue to outperform the returns of SPY as they did in the previous three cycles (see above chart).

What is the option market indicator saying about the strength of the market?

Source: StockChart.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the graphs of SPY in the upper panel with its 200-day moving average and the graph of the option market indicator in the lower panel. The message is quite simple. The option market indicator will have to decline to much lower levels to signal a major buying opportunity.

If history repeats itself, the decline of this indicator is likely to last at least one year. The market, meanwhile, will struggle to make further gains as it did in previous cycles. This indicator is regularly updated in each issue of the Peter Dag Portfolio Strategy and Management. Readers of this article may enter an exclusive complimentary subscription on www.peterdag.com.

Key takeaways

  • Business activity will slow down as long as the option market indicator declines.
  • Commodities and yields will decline as long as the option market indicator declines.
  • Total returns from TLT will continue to outperform those of SPY as long as the option market indicator declines.
  • A major buy opportunity in stocks will occur when the option market indicator declines to much lower levels – a process likely to last at least one year.

Yields To Fall To European Levels

Summary

  • The monetary policy followed by the US is like the one followed by Europe and Japan. It is likely to achieve the same results.
  • The amount of debt issued will force the economy to grow slowly. Government dictated demand management will keep producing disappointing results.
  • The sagging velocity of money re-enforces the cautious tone about the economic outlook.
  • The outcome is yielding to fall to European levels below 1.0%.

My second article suggested bonds were likely to outperform the S&P 500 because of developing trends of the business cycle. The article can be found here.

Wall Street follows the wild gyrations of the economy after the 2020 lockdown and tries to rationalize the wildly fluctuating growth rates never seen in our history – an impossible task.

What we are experiencing is pure abnormality. What is normal are the main forces driving the market for the next several months: our long-term growth potential, the levels of debt, the business cycle, and the effects of misguided government/monetary policies.

The long-term growth of the US economy is about 2.5%. Recent growth rates of 10% or even 5% are temporary and have only one implication – economic growth rates will drop in a major way. This tendency will have a negative impact, capping yield levels.

Another important consideration is the role of debt. I have discussed in detail this subject here. C. M. Reinhart, V. R. Reinhart, and K. S. Rogoff studied extensively the historical implications of high debt on economic growth in many countries since 1800.

The bottom line is nations sporting debt well above 100% of GDP are bound to grow slowly. Their conclusions apply perfectly to what has been happening to Europe, and Japan. Italy is also a typical long-term example. They all suffered stagnation accompanied by negative, or close to zero percent, bond yields for several years.

Can the US be immune to this disease? It is doubtful. It is no coincidence the steadily increase in debt in the US has been accompanied by gradually and gradually slower economic growth. And steadily slower growth has been accompanied by steadily lower yields.

Pie chartDescription automatically generated
Source: The Peter Dag Portfolio Strategy and Management

Another impact on yields is the business cycle. The downturn of the business cycle (Phases 3 & 4) reflects a significant slowdown in business activity. This is the time when portfolios should avoid cyclical sectors and be overweight defensive sectors and bonds.

The decline of the business cycle is anticipated by rise in commodities and inflation which undermine consumers’ purchasing power. The slowdown in demand is not recognized at first by business which remains mainly focused on replenishing inventories. The fear of losing sales forces business to ramp up production to meet sales.

Eventually inventories start rising faster than sales. The inventory to sales ratio rises and production needs to be cut to protect profits.

The reduction in production requires a cut in working hours. The cut in working hours is followed by layoffs, reduction in purchases of raw materials and borrowing to finance operations.

The forces unleashed by the inventory correction are visible in slower growth in manufacturing employment, declines in commodity prices, and lower yields.

ChartDescription automatically generated
Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows our real-time business cycle indicator (lower panel) which is updated in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary subscription is available to the readers of this article. The yields on the 10-year Treasury bonds are shown in the upper panel.

Since 1910 there have been three completed business cycles. The most recent business cycle started in March 2020. The graphs show yields rise when the business cycle rises. They decline when the business cycle declines.

The trends in commodities and inflation and the gaining of relative strength in long-term Treasury bond prices (TLT) (discussed in the articles mentioned above) suggest we are close to the transition of the business cycle from Phase 2 to Phase 3.

The implication is yields are likely to move lower for the duration of the decline of the business cycle which could last about 2 years according to the historical norm.

There is another major force acting on yields and driving them lower. The velocity of money is a measurement of the rate at which money is exchanged in an economy. It is the number of times money moves from one entity to another. It reflects how much a unit of currency is used in each period. Simply put, it is the rate at which consumers and businesses in an economy collectively spend money.

The above chart shows the graph of the velocity of money measured as a ratio of gross domestic product to the money supply M1. The velocity of money is important for measuring the rate at which money in circulation is being used for purchasing goods and services. The second line is the yield on 10-year Treasury bonds.

M1 includes the most liquid portions of the money supply because it contains currency and assets that either are or can be quickly converted to cash.

There are two crucial patterns in the chart. Money velocity has been declining steadily since 2008. It reflects the idea the Fed is “pushing on a strong”. The liquidity is placed in circulation by the Fed does not stimulate economic transactions strongly enough to stimulate the economy. It is no coincidence the reserves at depositary institutions soared close to $4.0 trillion.

The point is there is a lot of liquidity in the system. This liquidity is not stimulating growth as reflected by a sagging velocity of money.

The above chart shows also bond yields have been following closely M1 money velocity in its decline. Yields are declining because Washington is attempting to solve the issues of the economy by giving people “stimulus money” rather than stimulating productive investments.

Demand management does not work, and my previous articles listed above have documented the long-term downward trends of the growth of the US economy.

The US, Europe and Japan have experienced massive debt creation with the illusion it would stimulate their economies. Exactly the opposite has happened. The outcome is after decades of monetary failure yields on government bonds have been stagnating close to zero percent for a long time in Europe and Japan.

What has been happening to Europe and Japan is what we should expect in the US. Yields will drop close to zero percent reflecting the failure of printing absurd quantity of money for the purpose of demand management. Decades of this experience show it has been a failure,

The recent sharp increase in inflation is creating a negative feedback on consumer spending. It is already happening to the housing sector. Eventually consumers recognize their spending power has being seriously curtailed. Declining purchasing power will trigger the transition of the business cycle from Phase 2 to Phase 3.

The bond market is perfectly aware of the inflation conundrum. Bonds are looking at the misguided economic policy which will create stagnation and much lower bond yields.

Key takeaways

  • The decline in the velocity of money and the slowdown in economic activity (decline of our business cycle indicator) will keep placing downward pressure on yields.
  • The debt level will force the economy to grow slowly as already demonstrated by Europe and Japan. These economic blocs have clearly shown aggressive printing of money has resulted in a slow growth economy and historically low yields.
  • The US is following the same path as Europe and Japan, and it is likely to achieve the same results.
  • Yields are likely to decline to European levels below 1.0% for the next two years as the business cycle keeps heading lower.

Buy Bonds For A Trade. Part 2.

Summary

  • There are times bonds offer great returns.
  • There are times bonds are a poor investment.
  • There are times bonds are a superb hedge for investment portfolios.

On March 1, 2021, I published Buy Bonds For A Trade. On 2/26/2021 TLT was trading at 141.07. It bottomed on 3/18/2021 at 134.75. It has appreciated since then as yields declined.

Wall Street cannot explain why yields are declining – and bond prices rise – with massive government deficits, debt, and historically easy and inflationary monetary policy.

The trading outlook for bonds in the above article was based on this analysis.

“The time to sell TLT (iShares 20+ Years Treasury Bond ETF) took place when its price spiked with unusually heavy volume in March 2020. This pattern is a reliable indicator to sell any asset displaying it. It is a signal big sellers (strong hands) are trying to attract buyers (weak hands).

March 2020 was also the time the business cycle bottomed. Since then, TLT stopped rising, and finally began to decline in August 2020 – down about -18% as of this writing.

The change over 200 days in the price of TLT has dropped to levels associated in the past with an attractive trading opportunity – as in 2009, 2011, 2014, 2015, and 2017 … (Emphasis added).”

It was a technical call, based on the rate of change of TLT which had reached extremely low levels. The analysis discussed in March still holds, suggesting yields are more likely to decline than rise.

There are also long-term fundamental forces slowly emerging placing downward pressure on yields. The process will take a few months, but these forces will strengthen, forcing yields to keep heading even lower.

Pie chartDescription automatically generated
Source: The Peter Dag Portfolio Strategy and Management

In Phase 1 of the business cycle business recognizes inventories have been cut too aggressively during the slowdown period (Phase 4). Business needs to increase inventories. This feat requires boosts in production, workers, raw materials, and capital to expand and improve the production process. The outcome is rising employment and commodities. Bond yields bottom in this phase. This is what has happened in March 2020.

In Phase 2 demand keeps strengthening as more jobs are created. Business is growing rapidly and manufacturing still tries to catch up with sales. Commodities and bond yields rise. Inflation is also raising its ugly head. This is what has been happening in 2021.

In Phase 3 demand starts to slow down as rising inflation and interest rates dampen consumers’ enthusiasm. Business does not recognize this new trend and keeps producing. Eventually inventory levels rise to levels hindering earnings. Production must be cut. Capital needs decrease. Raw materials and bond yields decline as demand wanes. Employment is also reduced because of reductions in production.

In Phase 4 business keeps cutting output to protect earnings. Eventually, however, the cut in inventories becomes excessive. Finally, business recognizes this imbalance and decides to start increasing production. And Phase 1 starts again.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Since March 2020 business has been responding to pent-up demand by aggressively increasing production to replenish inventories. It had to increase its borrowing to finance its operations – hiring workers, purchases of raw materials, increases and improvements of productive capacity.

It is therefore no coincidence yields rise when the business cycle indicator increases. Yields decline when the business cycle indicator declines reflecting a slowdown in the demand for funds by business (see above chart). The business cycle indicator is updated in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary subscription is avalable on www.peterdag.com.

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Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management.

When you throw a stone in the water the first wave is big. Then the disturbance is followed by smaller and smaller waves. Any system reacts in this way when subjected to a major shock.

The US economy is not immune to the pandemic shock which has been transmitted through the economy and financial markets.

The above chart shows the change in average weekly hours of production on a month-to-month basis. You can recognize the “waves” in the change of the weekly hours of production.

The percent change measured on a year-over-year basis shows strong growth rates mostly because changes are compared to the low bases of 2020. The month-over-month data, however, indicate what is happening in a more granular way.

Hours worked is a leading indicator of employment. Reduction of the labor force is the decision of last resort because of its associated costs. Reduction in hours worked is a less costly decision when production has to be reduced when inventories are rising too rapidly.

Since February there have been four out of five months when hours worked were reduced. The reduction in hours worked of the past five months reflects the business uneasiness with current business growth and expectations.

Slowly the economic system is heading toward its long-term growth rate. The long-term growth of the US is productivity growth average (recently 1.5%) and population growth, currently 0.4%. The sum of the two is the expected growth of the economy – close to 2%. The weakness in copper and lumber suggests the process is under way.

Another important consideration is the role of debt. I have discussed in detail this subject here. C. M. Reinhart, V. R. Reinhart, and K. S. Rogoff studied extensively the historical implications of high debt on economic growth in many countries over centuries. Their conclusions apply perfectly to what is happening now.

The implication of their wide-ranging studies suggests growth will remain depressed as the economy is strangled by the transfer of wealth from interest payers to the bond holders, further enhancing income differential.

The fundamental direction of the economy is to slowly reach growth of about 2%. More money is printed, and more adverse results are achieved. It will be proved what history has shown extensively throughout the centuries – printing money without increases in productivity growth causes stagnation.

Let’s see how the equity and bond markets are reacting to this news.

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Source: The Peter Dag Portfolio Strategy and Management

The above chart shows the ratio of SPY (SPDR S&P 500 ETF Trust) divided by TLT (iShares 20+ Year Treasury Bond ETF) in the upper panel. The total returns of SPY are greater than those of TLT when the ratio rises. During such times it pays to be invested in SPY rather than TLT.

SPY outperformed TLT from 2004 to 2007, from 2009 to 2011, from 2012 to 2014, and from 2016 to 2018.

However, the total returns of TLT outperform that of SPY when the ratio declines. TLT outperformed SPY from 2007 to 2009, from 2011 to 2012, from 2014 to 2016, and from 2018 to 2020.

The interesting part of these statistics is TLT has outperformed SPY for about two years when our strategic indicator (lower panel) declines, reflecting a slowdown in business activity. The strategic indicator is updated regularly in The Peter Dag Portfolio Strategy and Management on www.peterdag.com.

During such times portfolios should be mostly invested in TLT for two reasons. The first one is TLT offers greater returns than SPY. The second reason is TLT provides an excellent hedge by reducing portfolio’s volatility when the business cycle declines.

Please note, this relation does not say bonds always outperform stocks. It simply says the total return of TLT outperforms the total return of SPY when the strategic indicator declines.

The indicator in the lower panel suggests we have entered a period when TLT will continue to outperform SPY as it has been doing since May 2021.

Key takeaways

  • The long-term growth potential of the economy is close to 1.5%-2.0% (productivity plus employment growth).
  • The economy through successive “waves” will irregularly slow down to these levels.
  • The business cycle is close to a peak, a process likely to take place over the next several months.
  • TLT has been outperforming SPY since May 2021.
  • The strategic indicator suggests the market has entered a period when TLT will continue to outperform SPY.
  • When the strategic indicator declines, TLT is a hedge against market weakness. It decreases the volatility of an investment portfolio and makes its performance more predictable.
  • SPY outperforms TLT when the strategic indicator rises, and the business cycle is in Phase 1 & Phase 2.

Commodities And Yields are declining. This Is Why.

Summary

  • A stone thrown in a pond makes smaller and smaller waves.
  • Any system subjected to a shock responds irregularly until it reaches equilibrium.
  • Any economy subjected to a shock responds with oscillating random waves until it reaches its long-term growth rate.

A rise in the inventory to sales ratio means inventories are rising faster than demand. The business response is to reduce them. Production needs to be cut. Purchasing of raw materials must be reduced. Hours worked and labor is lowered. Borrowing is also curtailed since less capital is needed to finance operations.

The market response to these decisions is declining commodity prices and interest rates.

The opposite takes place when the inventory to sales ratio declines, reflecting the need to replenish inventories since sales are outstripping inventory growth. Production needs to be raised. Purchasing of raw materials must be increased. Hours worked and employment are expanded. Borrowing is also increased since more capital is needed to finance operations and capacity expansion.

The market response is higher rising commodity prices and interest rates.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

The above chart shows the change in the inventory to sales ratio of three industrial segments: manufacturers, wholesalers, and total business.

The inventory to sales ratio (April data) has been sinking, reflecting demand outstripping supply by a wide margin. The last time it happened with similar violence was during the great recession of 2008-2009. Businesses will continue to respond by aggressively increasing production. This is the major business activity supporting the economy until inventories are growing at the same pace as sales.

The weakness in commodities and yields will provide an important clue whether inventories are finally outstripping demand and there is an unwanted inventory accumulation. It will take a few more months to find out. Commodity prices, however, being an important leading indicator, will provide important clues on the direction of the business cycle.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

This chart shows the percent change on a month-to-month basis of sales, durable goods orders, and autos. The graphs show the growth patterns of these crucial sectors. The economy is oscillating like the waves generated by throwing a stone in the water.

The first big wave was caused by the lockdown of March 2020. The system boomed until May 2020, followed by a slowdown ending in Nov 2020. We experienced another wave which peaked in May 2021. The current decline shows the economy slowing down again. It will eventually reach its growth potential of 1.5%-2.0%.

The economy will have to continue to slow down to a growth rate lower than 2%. The reason is productivity growth is about 1.0% and population growth is 0.4%. The average growth rate of business activity is computed by adding these two numbers. No government program can stop this natural process.

This development is the main reason for the continued decline in commodities and bond yields.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

This chart shows percent changes on a month-to-month basis of employment in manufacturing and construction. The employment situation in construction and manufacturing gives mixed pictures. Employment in construction has declined, confirming the weakness in housing and the decline in lumber prices. Manufacturing employment will stay firm thanks to the ongoing manufacturing effort to rebuild inventories.

Source: Cass Information Systems, Inc.
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Source: SockCharts.com, The Peter Dag Portfolio Strategy and Management

Shipping activity is still strong. This trend confirms the health of the manufacturing sector. The goods produced to replenish inventories must be shipped, thus causing the index to surge. It also explains the strength in crude oil prices – one of the few commodities resisting the decline.

The above chart shows the trending and gradually slower growth of the economy is confirmed by the broad decline in the major commodities – from soybeans to copper to lumber – except crude oil.

Key takeaways

  • The economy is trying to find its equilibrium growth rate which is close to 1.5%-2.0%, down from the current 10+%.
  • The various stimulus programs emanating from Washington generate random forces, further creating uncertainties and delaying the healing process of the economy caused by the lockdown of March 2020.
  • As the growth rates of the economy decline from the recent absurd 10+% to less than 2.0%, the markets will respond by placing continued downward pressure on commodities and yields.
  • Bonds (TLT) will keep appreciating, creating profit opportunities, and providing an attractive hedge to equity portfolios.

Stocks vs Bonds. A Portfolio Allocation Strategy

Summary

Bonds are purchased for capital gains.

Bonds outperform stocks for periods of up to two years.

The business cycle is the strategic tool to help you decide when to hold them.

There are periods lasting up to two years when bonds outperform the stock market (ETF: SPY). This article explores the timing model showing when bonds’ appreciation outpaces the market (SPY). The focus here is investors buy bonds for capital gains not for income, recognizing total return is an important metric.

Bond prices are driven by four basic factors: duration, risk, liquidity, and interest rates level. The impact of these variables on bond prices is studied in detail in the classic book by M. L. Leibovitz and S. Homer “Inside the yield curve”. The ETF TLT is used here as a proxy for bonds. TLT seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.

TLT is the safest bond portfolio because it is invested in US Treasury obligations. TLT holdings have a long maturity and long-maturity bonds have the greatest price change when interest rates change.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

The above chart shows 10-year Treasury bond yields (blue line) and the growth of GDP after inflation (red line). The chart shows the long-term trend of yields follows closely the growth of real GDP. In other words, economic growth and inflation are the main determinants of the long-term trend of 10-year Treasury bonds.

If investors believe the long-term growth of the economy after inflation is 2.0%, they should also assume yields are likely to trade close to 2.0%. Of course, much is being said about the action of the Fed and the government. Whatever they do, the ultimate impact of their actions is on economic growth after inflation. Despite, or because of, the programs launched in the past two decades, the trend of economic growth has been declining and is now below its long-term average. I discussed in detail the reasons here.

From a portfolio strategy viewpoint, the profit and hedging opportunities arise by using the business cycle framework.

Source: The Peter Dag Portfolio Strategy and Management

The simplest way to look at the business cycle is to examine the decisions made by executives to control inventory levels. It is a way to relate price moves to business decisions rather than exogenous and unexpected events.

Business, following a period of protracted economic weakness (Phase 3 & 4) recognizes it does not have enough inventory to meet demand. The decision to increase inventory levels involves an increase in production (Phase 1). This process requires hiring new workers, boosting the purchase of raw materials (commodities), and raise the level of borrowing to meet current operations and invest to improve capacity.

The outcome of these decisions is to bolster demand as more workers find jobs, and place upward pressure on commodities and interest rates. This is the time the business cycle moves from Phase 1 to Phase 2.

The process reinforces itself until it reaches extreme conditions. Toward the end of Phase 2 inflation becomes a concern while interest rates reach levels discouraging the purchase of big-ticket items and new homes.

The decline in purchasing power forces the consumer to reduce spending. Business at first does not recognize this change. Eventually the rise in inventories has a negative impact on earnings. Business decides to reduce inventories to protect profitability. Workers are laid off, raw material purchases are reduced, borrowing is curtailed to reduce interest costs.

The business cycle is now going through Phase 3 and Phase 4 until wages, inflation, commodities, and interest rates decline enough to stimulate again consumers’ demand.

This is the time Phase 1 starts all over again. Economic strength improves and the markets react to these changing conditions.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Let’s see now how these actions impact bond yields and their relationship with the stock market. The trend of bond yields reflects closely the business decisions to manage the inventory cycle. The above chart shows the yield on the 10-year Treasury bonds (upper panel) and the business cycle indicator updated in real-time and reviewed in each issue of The Peter Dag Portfolio Strategy and Management. (An exclusive complimentary subscription is available to the readers of this article.)

The chart shows yields rise when the business cycle rises, reflecting the efforts to finance the re-stocking of inventories and improve and increase productive capacity. Yields decline, however, when the business cycle declines, due to the reduction in production and financing needs. The point is bonds tend to appreciate (bond yields decline) when the business cycle declines. Bond prices are likely to decline (bond yields rise) when the business cycle rises.

The relationship is particularly noticeable because nothing has been said about the action of Congress or the Fed to “drive” the markets. The data to compute the business cycle graph come exclusively from real-time market data.

The relationship between bond prices (TLT) and the market (SPY) provides a useful strategic tool. TLT prices move inversely to the trend of yields ($TNX in the above chart).

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The ratio of SPY and TLT is shown in the upper panel. SPY outperforms TLT when the ratio rises. SPY underperforms TLT when the ratio declines. The lower panel shows the business cycle indicator discussed in every issue of The Peter Dag Portfolio Strategy and Management and is updated on a real time basis using market data on www.peterdag.com.

TLT has outperformed SPY for periods of up to two years during a complete business cycle. The relationship shown on the above chart is important for two major reasons. In a period when the economy slows down and the business cycle declines, a portfolio heavily exposed to long-term bonds such as TLT is likely to outperform SPY.

The second major advantage in overweighing bonds during a decline in the business cycle is its hedging features. For instance, during the business cycle decline of 2018-2020 a portfolio overweighted in TLT offered great strategic advantages due to the market collapse because of the economic slowdown started in 2018 and culminating with the crash of March 2020 due to the pandemic. This event signaled the bottom of the business cycle (see above chart).

Since March 2020, as the business cycle kept rising, SPY has outperformed TLT in line with previous patterns. A decline of the business cycle will cause TLT to outperform SPY as it did in 2018-2020, 2014-2015, and 2011-2012.

Key takeaways

  1. Bond prices rise and yields decline when the business cycle declines (Phases 3 & 4 of the business cycle).
  2. Bond prices decline and bond yields rise when the business cycle rises (Phases 1 & 2 of the business cycle).
  3. Bonds outperform stocks for their capital appreciation and are attractive for their hedging features when the business cycle declines.
  4. Stocks outperform bonds when the business cycle rises, signaling a stronger economy.

For a look at all of today’s economic events, check out our economic calendar.

Berkshire, Metals, Financials, and Gold.

  • Berkshire has not been acting as in the past during the last several years.
  • Its performance depends on its portfolio.
  • The business cycle helps to understand the change.
Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the price of Berkshire in the upper panel. The lower panel shows the business cycle indicator as updated in real time in each issue of The Peter Dag Portfolio Strategy and Management.

The business cycle indicator reflects the decision of business managers to replenish depleted inventories. A rising business cycle indicator measures the strength of the activities needed to replenish inventories – the purchase of raw materials, hiring of new workers, and the increase of borrowing to finance new capacity and ongoing operations.

During such times commodities, wages, interest rates, and overall inflation rise. The equity markets respond by favoring industrial, material, financial, and energy stocks. Defensive sectors such as utilities, staples, health care, and bonds underperform the market during this period.

The business cycle peaks because rising interest rates, energy prices, and overall inflation reduce consumers’ purchasing power. The outcome is slower growth in demand. Business does not recognize what is happening and lets inventories build up.

Eventually, rising inventories have a negative impact on profitability. Business is forced to cut production to reduce inventories. It decreases purchases of raw materials, cuts the labor force. It also borrows less to reduce interest costs. The outcome is lower commodity prices, lower wages, and lower interest rates. The result is steadily declining inflation.

During such times sectors such as staples, healthcare, utilities, and bonds outperform the markets. Cyclicals, industrial, metals and mining, and financials underperform the markets.

Despite its phenomenal performance, Berkshire stock responds to the trend of the business cycle. A decline in the business cycle indicator, indicating slower economic growth, is reflected by a slowdown in the price appreciation of Berkshire (see above chart). The sharpest gains in its stock price take place when the business cycle rises and the economy strengthens.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the business cycle indicator in the lower panel. The upper panel shows the performance of Berkshire compared to metal and mining stocks (ETF: XME). The graph is obtained by dividing the price of Berkshire by the price of XME.

The graphs show XME outperforms Berkshire (the ratio decline) when the business cycle rises due to a strengthening economy. When the economy weakens and the business cycle declines, Berkshire outperforms XME.

The above chart is similar to the relationship between XME and gold discussed in detail here.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the business cycle indicator in the lower panel. The relative performance of BRK/B and gold is shown in the upper panel. BRK/B outperforms gold when the business cycle rises, and the economy strengthens. On the other hand, BRK/B underperforms gold when the economy is weakening, and the business cycle declines.

I discussed here the cyclical pattern of bank stocks and how they relate to interest rates (not that obvious). One of the points of the article was bank stocks have a pronounced cyclical behavior. They outperform the market (SPY) when the business cycle rises. They underperform the market when the business cycle declines. These tendencies are similar to those of BRK/b (see first chart).

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows in the upper panel the performance of Berkshire compared to SPY (the graph shows the ratio of the price of Berkshire divided by SPY). The chart shows Berkshire outperforms SPY when the business cycle strengthens. It underperforms SPY when the business cycle declines. In other words, Berkshire performs like a bank stock during the business cycle.

Key takeaways

  1. Berkshire outperforms the market when the business cycle rises. It underperforms the market when the business cycle declines.
  2. Berkshire responds like a bank stock to the trend of the business cycle.
  3. Berkshires outperforms gold when the business cycle rises and underperforms gold when the business cycle declines.
  4. XME outperforms Berkshire and gold when the business cycle rises.
  5. XME underperforms Berkshire and gold when the business cycle declines.

Investing In Foreign Markets Sounds Exciting – But Isn’t Always – Part 2

Summary

  • Global business cycles are closely interconnected and synchronized.
  • Global equity markets reflect the policies of their leaders.
  • Global equity markets respond accordingly.

The conclusion was the global business cycles are perfectly synchronized and so are their major tops and bottoms of their equity markets. This article is updating the above article and looks at the most recent relative economic performance of their business cycles and markets.

Source: The Peter Dag Portfolio Strategy and Management

The main force driving the US business cycle is the need to keep inventories growing at the same pace as sales as discussed in detail here.

During Phase 1 & 2 of the business cycle (see above graph), business increases production, hires more workers, buys more raw materials, and increases borrowing to meet its operational needs. The virtuous cycle (positive feedback) lasts until the end of Phase 2.

At the end of Phase 2, soaring commodity prices such as crude oil, lumber, copper, and rising wages, and interest rates create an inflationary environment causing consumers to become more cautious about their spending.

The slowdown of demand causes a negative cycle (negative feedback). Business is forced to reduce the growth of inventories by cutting raw material purchases, laying off workers, and reducing borrowing. The business cycle is now in Phase 3.

The business cycle goes through Phases 3 & 4 until the causes that induced the slowdown are brought under control. At that time consumers will recognize their purchasing power has increased again due to the decline in commodities, inflation, interest rates, and inflation. Demand increases and the virtuous cycle starts all over again with Phase 1.

Source: OECD

The above chart shows the global business cycle as published by the OECD.

The OECD defines the graph as a leading indicator of the economy. A practical way to look at the graph is as standing for the fluctuations of the economy around an average growth rate (the horizontal line going through 100.)

Since 2009 the global economy has experienced three business cycles: 2009-2013, 2013-2016, and 2016-2020. Since March 2020, the global business activity has begun a new business cycle.

The current position of the indicator is slightly above 100, suggesting the global economy is growing slightly above its long-term average pace.

Source: OECD

The EU area indicator has the same cycles of the global economy. Growth, however, is more muted and still below its historical average. It reflects the economic and political idiosyncrasies affecting the continent.

Source: OECD

The Chinese business cycle has the same turning points as the global cycle. Growth is estimated to be strong for China, according to the OECD data. This conclusion is not confirmed by the latest Markit purchasing managers index for China and by the muted action of the Shanghai index.

C:\Users\gdagn\Documents\SEEKINGALPHA\BUS CYCLE INDICATOR 5-22-2021.jpg
Source: The Peter Dag Portfolio Strategy and Management

The above chart shows the US business cycle indicator as updated in each issue of The Peter Dag Portfolio Strategy and Management. The US business cycle, as computed from market data in real time, shows the same turning points of the above business cycles released by the OECD. An exclusive complimentary subscription is available to the readers of this article on https://www.peterdag.com/.

C:\Users\gdagn\Documents\SEEKINGALPHA\VEU 5-22-2021.jpg
Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the performance of the global stocks market ex-US (VEU). The lower panel shows the relative performance of VEU compared to the S&P 500 (SPY). The downtrend of the line shows the persistent underperformance of the global market compared to the US market since 2007.

The chart also shows the cyclical nature of the global equity market with the major bottoms taking place at the bottom of the business cycles (2009, 2012, 2016, and 2020).

C:\Users\gdagn\Documents\SEEKINGALPHA\IEV 5-22-2021.jpg
Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the performance of the European stock market (IEV). The lower panel shows the performance of IEV compared to the US market. The European market has the major bottoms coinciding with the bottoms of the global business cycle. The European market has persistently underperformed the US market since 2007, as reflected by the declining line in the lower panel.

C:\Users\gdagn\Documents\SEEKINGALPHA\SHANGHAI INDEX 5-22-2021.jpg
Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the performance of the Shanghai index. As in the earlier graphs, the Chinese market has the same cyclical bottoms as those of the other global economic areas. The equity market has underperformed the US market since 2007 as shown by the declining line in the lower panel of the chart.

Key takeaways

Since last November, trends are still unchanged with global business cycles still trending up.

Global business cycles are perfectly synchronized and have the same turning points despite differences in language, social habits, business cultures, and political systems.

Global equity markets have the same turning points at major tops and bottoms. The investment decision is therefore about which market will display more volatility. The risk-adjusted return of the portfolio may be affected by this decision.

Major foreign equity markets continue to underperform the US market.

Relative performance among equity market reflects relative economic performance based on which country has the soundest and more growth oriented economic policies.

Investing in a foreign market is not necessarily a hedge to a portfolio performance because foreign equity markets tend to move in the same direction as the US market.

For a look at all of today’s economic events, check out our economic calendar.

The Inventory Cycle – Boring But Important Market Setter. Part 2.

Summary

  • Government and Fed stimulus create volatility.
  • But businesses must navigate through it and replenish the shelves.
  • Inventory management moves the markets.

What is the “boring indicator” saying now?

Source: The Peter Dag Portfolio Strategy and Management

Business managers must filter all the news coming from different sources such as pandemics, cartels, supply chain difficulties, foreign or domestic supplier availability, trends in commodities and interest rates, changes in value of the dollar, and the Fed. They must make a crucial decision: how much to produce to replenish the inventories at levels needed to meet the demand for their goods.

The business cycle transitions through four phases as management changes its inventory policies. In Phase 1 and Phase 2 business decides to build inventories to meet growing demand. This decision results in increases in the purchase of raw materials, hiring more people, increase in borrowing to finance operations and improve and expand capacity.

This is the time the business cycle grows through Phase 1 and Phase 2. This is also the time commodities, copper, crude oil, lumber, agricultural, interest rates, and inflation rise. The increase in these prices is a testimonial the economy is strengthening.

The problem arises toward the end of Phase 3. The continued rise in commodities, crude oil, and inflation eventually reduces consumers’ purchasing power in a meaningful way. The response is a slowdown in spending.

In Phase 3 managers begin to experience rising inventories compared to sales with a direct impact on their financial performance. The need to reduce inventories involves cuts in the purchase of raw materials, reduction in the workforce, and declines in borrowing. This process will continue until inventories are in line with demand. The inventory to sales ratio keeps rising during these times. During Phase 3 and Phase 4, because of the action of business, commodities decline, wages slow down, and interest rates decline.

When inventories are finally adjusted to the desired level matching their growth with the growth of demand, the business cycle transitions from Phase 4 to Phase 1. At this point the inventory to sales ratio starts rising again. It reflects sales rising faster than inventories. Business will have to increase production to restock inventories. And the business cycle moves to Phase 1. The markets will respond promptly as discussed in detail in my article here.

Source: U.S. Census Bureau

The inventory to sales ratio published by the U.S. Census Bureau gives a good sense of where we are in the business cycle. A rise in the ratio means inventories are rising faster than sales. In this case investors should expect busines to cut inventories.

The inventory to sales ratio declines when sales rise faster than inventories. Busines is forced to increase production to replenish inventories. They must do so if they do not want to lose sales.

Since November, the inventory to sales ratio kept moving lower.The current sharp decline in the inventory to sales ratio suggests sales are rising much faster than inventories, forcing managers to keep increasig production. The markets have reacted exactly as they have always done during Phase 1 and Phase 2 of the business cycle when the inventory to sales ratio is heading lower – a strong economy, rising commodities, rising interest rates, rising inflation, and strong cyclical sectors.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows (from top to bottom) the graphs of the 10-year Treasury bond yields, and the price of copper, crude oil, lumber. The business cycle indicator is shown in the bottom panel as updated in each issue of The Peter Dag Portfolio Strategy and Management on www.peterdag.com. An exclusive complimentary subscription is available to the readers of this article.

The chart shows a rising business cycle is accompanied by an increase in yields and commodity prices. Commodities and yields decline when the business cycle declines. For instance, the business cycle increased from 2016 to 2018 and copper, crude oil, lumber, and interest rates increased. The business cycle has been rising since March 2020 and yields and commodities have been rising since then.

The November article also suggested commodity sensitive stocks such as Caterpillar (CAT) and Freeport-McMoRan Inc. (FCX) were likely to outperform the market in response to the rise of the business cycle.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows (from top to bottom) the ratio of CAT divided by SPY, the ratio of FCX divided by SPY, and the business cycle indicator. An increase in the ratio reflects the outperformance of the stocks compared to the market.

Key Takeaways

The trends reviewed in my article of November 24, 2020 are still in place.

The inventory to sales ratio keeps declining, pointing to continued strength in manufacturing.

The implication is commodities and interest rates are likely to rise as long as the inventory to sales ratio is declining, indicating sales outstripping inventory accumulation, and the business cycle indicator is rising.

Commodities and interest rates will peak when the inventory to sales ratio starts rising, indicating inventories rising faster than sales, and the business cycle indicator declines.

Commodity-sensitive stocks such as CAT and FCX will continue to outperform the market as long as the inventory to sales ratio declines and the business cycle rises.

A rise in the inventory to sales ratio and a decline in the business cycle indicator will suggest a change in portfolio asset allocation from cyclical to defensive sectors.

DGRO And NOBL. Dividend Growth Stocks. Great Investments. Some of the time.

Summary

  • They are superb long-term investments.
  • The reason they have underperformed since March 2020.
  • A look at the risks, opportunities, and alternatives.
Source: S&P Dow Jones Indices

The above table published quarterly by S&P Dow Jones Indices makes the point quite clearly. It shows an investment strategy based on dividend-paying stocks not only has had superior returns but these returns have been achieved with exceptionally low volatility when compared to other strategies.

But the performance could be improved if investors considered the impact the business cycle has on a portfolio of dividend-paying stocks as represented, for instance, by the two ETFs NOBL or DRGO.

Source: The Peter Dag Portfolio Strategy and Management

Phase 1 and Phase 2 of the business cycle are characterized by the business decision to replenish inventories following the cuts they had to make in Phase 3 and Phase 4. To replenish inventories, business must buy raw materials, hire more workers, and borrow money to finance the operation, improve and expand capacity.

The virtuous cycle (positive feedback) of hiring, producing, and borrowing strengthens the economy. In phase 2 business activity is strong with the economy growing at an above average pace. This is the time when commodities rise rapidly, accompanied by rising wages and interest rates. In other words, inflation is now becoming an issue.

As business fills up capacity, productivity declines, placing upward pressure on labor costs and hindering profitability.

When consumers’ demand wanes due to the decline in purchasing power, business is forced to cut inventories to match slower sales and to protect profitability. Raw material purchases are reduced, workers are laid off, and borrowing is cut. These decisions bring detrimental results (negative feedback) throughout Phase 3 and Phase 4.

At the end of Phase 4, because of the reductions implemented by business, commodities, inflation, and interest rates are declining. Productivity improves because of lower capacity utilization and profitability hedges higher.

The improvement in purchasing power due to the decline in inflation begins to stimulate demand. Business realizes it must replenish inventories and Phase 1 starts all over again.

Investors can benefit as the business cycle moves through its phases. Phase 1 and Phase 2 are characterized by increases in the price of most assets: energy, metals, most commodities. Rising interest rates are also a feature of this period. Investment in cyclical stocks, as discussed in details in my article An Indicator That Assesses Which S&P 500 Sectors Are Likely To Outperform is particularly attractive in these phases. During Phase 3 and Phase 4, on the other hand, defensive sectors such as staples, REITs, healthcare, utilities, and bonds tend to outperform the market.

The iShares Core Dividend Growth ETF (DGRO) seeks to track the investment results of an index composed of U.S. equities with a history of consistently growing dividends. The performance of this ETF confirms the results shown in the first chart by S&P 500 Dow Jones Indices. It is interesting to note, however, this ETF is particularly sensitive to the trends of the business cycle.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management.

BUSINESS CYCLE INDICATOR

To recognize its sensitivity to the business cycle we have prepared the above chart. The chart shows three panels. The upper panel shows the price of DGRO. The middle panel shows the relative performance of DGRO compared to metals and mining stocks (XME). This is done by computing the ratio DGRO divided by SPY.

The ratio rises when DGRO outperforms XME. DGRO underperforms XME when the ratio declines.

The lower panel shows the business cycle indicator, updated in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary issue is available to the readers of this article on www.peterdag.com.

Although DGRO has a solid long-term performance, the ETF is particularly attractive when the business cycle declines, reflecting a weakening economy.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management.

The above chart shows how the same relationship discussed for DGRO applied to the ETF NOBL – an ETF focusing on companies within the S&P 500 that have raised their dividends for at least 25 consecutive years.

The chart shows three panels. The upper panel shows the price of NOBL. The middle panel shows the relative performance of NOBL compared to metals and mining stocks (XME). This is done by computing the ratio NOBL divided by SPY.

NOBL outperforms XME when the business declines, reflecting a weakening economy. On the other hand, XME outperforms NOBL when the economy strengthens, and the business cycle rises.

Key takeaways

DGRO and NOBL are superb long-term investments as suggested by the data supplied by S&P Dow Jones Indices, showing a strategy based on an investment in dividend aristocrats produces above average returns with low volatility.

The investment results could be further enhanced by investing in DGRO or NOBL when the business cycle declines and investing in XME when the business cycle rises, reflecting a strengthening economy.

Small Cap Stocks – A Warning Signal For The Market

Summary

Small-cap stocks are great performers, some of the time.

They appreciate the most when the economy strengthens.

They give a reliable buy/sell signal when compared to staples.

The purpose of this article is to discuss its relationship with the business cycle and find out what are the periods IWM is particularly attractive as an investment.

Source: The Peter Dag Portfolio Strategy and Management

There are two distinct periods in a business cycle. The first one is the period the business cycle rises, reflecting an expanding economy. This period includes Phase 1 and Phase 2.

The second one takes place when the economy weakens, and the business cycle declines. This period is characterized by Phase 3 and Phase 4.

During Phase 1 and Phase 2 business finds out demand is growing, and inventories need to be replenished. Raw materials must be purchased. Workers need to be hired. Money needs to be borrowed to finance increased production and improve capacity.

The outcome is rising commodity prices, rising wages, and rising interest rates. The rise in wages further increases demand, forcing businesses to increase production. It is a virtuous cycle (positive feedback), stimulating growth. But accelerating growth cannot last forever.

Toward the end of Phase 2 the rise in production costs, the rise in inflation, and the rise in interest rates has a negative impact on consumers’ purchasing power. The outcome is a slowdown in sales.

In Phase 3 business finally recognizes inventory is accumulating because of slower demand. This is the time production and costs are cut aggressively. The result is a decline in purchases of commodities, reduction of the labor force with resulting declining needs for borrowing. Sales continue to slow down.

These activities feed on themselves (negative feedback) forcing businesses to become cautious about their business and production plans.

Eventually, the decline in costs (lower commodities, wages, and interest rates) restores profitability. Consumers’ power increases and interest rates and inflation decline. The effect is an increase in demand, forcing businesses to increase production to replenish depleted inventories. And Phase 1 is underway again.

The purpose of the following charts is to show the typical price action of small-cap stocks during the phases of the business cycle, especially as it relates to IWM performance compared to the S&P 500 (ETF: SPY).

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the IWM graph in the upper panel from 2006 to 2021 with its 200-day moving average. The lower panel shows the business cycle indicator as published in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary issue is available to the readers of this article.

IWM follows closely the pattern of the business cycle indicator. It appreciates rapidly when the business cycle rises, reflecting a stronger economy. IWM, however, pauses when the business cycle declines as the economy slows down.

IWM has been rising sharply since March 2020. It has traded in a range, however, since early February. Because of its past relationship with the business cycle, it may be interpreted as a sign the economy is on the verge of a slowdown.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the ratio of IWM and SPY. The ratio rises when IWM appreciates faster than SPY. The ratio declines when IWM underperforms SPY.

The performance pattern of IWM compared to SPY follows closely the business cycle indicator. The relation between the graphs in the upper and lower panels suggests IWM outperforms the broad market (SPY) when the business cycle rises, reflecting a stronger economy. On the other hand, IWM underperforms the market when the business cycle declines as the economy slows down.

A clearer recurring pattern of IWM is evident when it is compared to consumer staples stocks. This correlation is even more striking and useful from an investment viewpoint when IWM is compared to consumer staples stocks (XLP).

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows in the upper panel the ratio of IWM and XLP. The business cycle indicator is shown in the lower panel. The cyclicality of IWM is now clearer and suggests an attractive investment strategy.

The chart shows IWM outperforms XLP when the business cycle rises. It underperforms XLP, however, when the business cycle declines.

Particularly noticeable is the sharp decline of the ratio of IWM and XLP since late February. The pattern is quite similar to the other spikes that took place in 2011, 2014, and 2018. It is important to recognize the business cycle reached a peak and started to decline in those years. This decline warned investors they had to switch their strategy from cyclical stocks to defensive stocks and bonds.

Similar conclusions could have been reached by comparing IWM to TLT (iShares 20+ Year Treasury Bond ETF).

Key takeaways

IWM has the tendency to appreciate rapidly when the business cycle rises. It weakens when the business cycle declines, signaling slower economic growth.

IWM outperforms the market (SPY) when the business cycle rises. It underperforms the market when the business cycle declines.

IWM outperforms XLP (or TLT) when the business cycle rises. It underperforms XLP (or TLT) when the business cycle declines.

The current weak performance of IWM suggests the economy is likely to slow down.

The action of IWM compared to SPY and XLP (and/or TLT) suggests a procyclical investment strategy. Invest aggressively in IWM when the economy strengthens (the business cycle is in Phase 1 & 2). Sell IWM and invest in XLP (and/or TLT) when the business cycle declines (the business cycle is in Phase 3 & 4).