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.

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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.

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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.

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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.

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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.

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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).

Costco – The Stock Is Sending A Warning Message. Part 2.

Summary

  • Costco’s price pattern is closely related to the business cycle.
  • Costco outperforms the market when business slows down.
  • Costco has declined enough to make it attractive again.

As shown in my article of 12/15/2020 – Costco: A Great Defensive Play, The Issue Is Timing – Costco has distinct pattern closely tied to the business cycle.

The price action of Costco raises two questions. Is Costo likely to outperform the market? If so, what is its price action telling us about the future of the business cycle?

The importance of knowing where we are in the business cycle has major implications on what type of stocks should be in a portfolio.

Source: The Peter Dag Portfolio Strategy and Management

There are two crucial turning points of the business cycle. The first one is when business transitions from Phase 2 to Phase 3. The second point is when the business cycle moves from Phase 4 to Phase 1. Both points signal important changes in price performance of the major market sectors as discussed in detail here.

In Phase 2 of the business cycle business is facing strong demand and needs to replenish inventories to meet sales. The increased production is achieved by buying more raw materials, hiring more people, and increasing borrowing to expand and improve productive capacity.

The outcome of these decisions is higher commodity prices, rising wages, and higher interest rates. The combination of these factors is transmitted to the consumer as higher inflation.

In this phase of the business cycle commodity-sensitive stocks, industrials, energy, and financial stocks easily outperform the market.

The reason for this scenario to come to an end is rising interest rates and inflation have a negative impact on consumers’ spending power. The outcome is slower growth in demand resulting in unwanted inventory accumulation.

There is a point when business finally recognizes the economic landscape has changed and inventories need to be cut by reducing production.

The implication is buying raw materials needs to be curtailed, the workweek needs to be cut, and borrowing must also be reduced. These decisions will cause lower commodity prices, slower growth in wages, and lower interest rates. This is the time the business cycle transitions into Phase 3.

Beginning in Phase 3, sectors outperforming the market are utilities, staples, real estate, and bonds.

The current position of the business cycle is in Phase 2. The recent sharp rise in inflation, commodity prices, and interest rates suggests we are close to the Phase2-Phase 3 turning point.

The price pattern of Costco compared to the S&P 500 is particularly telling because it might give further information on the position of the business cycle.

COST/SPY

AND 200 DMA

SPREAD FROM 200DMA

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 COST and SPY. The second graph is its 200-day moving average. The graphs rise when COST is outperforming SPY. The graphs decline when COST underperforms SPY. Investors are going to outperform the market if they invest in COST when the graphs rise.

The bottom panel shows the spread between the ratio COST/SPY and its 200-day moving average. The resulting pattern is unique and quite interesting.

The first feature is the spread has now reached “oversold” levels (red horizontal line), signaling the beginning of a period when COST outperforms the market.

BUSINESS CYCLE INDICATOR

SPREAD FROM 200DMA

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

The second intriguing feature of the graphs is the spread is closely related to the business cycle as shown by the above graph. The spread between COST/SPY and its 200-day moving average is shown in the upper panel.

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

The interesting feature of the chart is the bottoms of the spread coincides with a peak of the business cycle. A peak of the spreads takes place when the business cycle bottoms.

The message is, and this should not be a surprise to the readers of the article published here, COST outperforms the market when the economy slows down.

Key takeaways

The transition of the business cycle from Phase 2 to Phase 3 signals the need to rebalance the investment portfolio.

The sharp increase in inflation, interest rates, and commodities we have been experiencing suggests we are close to the Phase 2-Phase 3 turning point of the business cycle.

The ratio COST/SPY has reached oversold conditions, coinciding in the past with a peak of the business cycle. These oversold conditions suggest Costco will continue to outperform the market.

The strength of Costo compared to the market may suggest investors are beginning to position their portfolios for the Phase 2-Phase 3 turning point of the business cycle.

Gold – Not So Precious

Summary

Three different assets: gold, bonds, and metals.

There is a significant relationship between them.

Which one is the best investment depends on the phase of the business cycle?

This article is about the relationships between the three so different assets – when to buy them and when to sell them.

Source

The business cycle is what drives the relative attractiveness of these three investments. And the business cycle is driven by business decisions to keep inventories at levels needed to meet demand and generate a profit.

The dynamics of the decision-making process is not simple. In fact, it is so difficult, mistakes are made. These mistakes cause turning points in the business cycles, and these turning points create unique opportunities for investors.

In Phase 2 (see above chart) the business cycle reflects a strengthening and overheating economy. Business is focusing on replenishing inventories because of strong demand. Purchases of raw materials, hiring of workers, and borrowing to finance capital improvement and expansion are fast-growing activities. For this reason, in this phase investors experience rising commodities, strong growth in employment and wages, and increasing inflation and interest rates.

In Phase 3 business ignores the fact inflation is rising in an alarming way. The outcome is purchasing power decreases and demand slows down. But business believes this weaker demand is a transitory event and decides to keep production humming to keep unit costs low.

Earnings, however, start declining as inventory levels increase to high levels when compared to demand. The decision is eventually made to cut inventories thus signaling the beginning of Phase 3.

The business cycle will have reached the end of Phase 4 when inventories are cut enough to re-establish profitability. Meanwhile, commodities, interest rates, and inflation have declined enough to restore consumers’ purchasing power.

Production will have to increase again to restock depleted inventories by hiring new workers. Commodities and interest rates stop declining while inflation may keep heading lower. Phase 1 is now underway.

The increase in demand, due to the improvement in purchasing power, forces businesses to add to inventories, eventually placing upward pressure on commodities, inflation, and interest rates. The business cycle is now again in Phase 2.

Where do we stand now as of this writing? Inflation is rising rapidly. Commodities are strong, interest rates have been moving higher. Employment in manufacturing is growing at a solid pace. The business cycle is in Phase 2. Further increases in inflation will force the business cycle to move into Phase 3.

Let’s see now how gold, metals, and bond prices behave at the turning points of the business cycle and find out an optimum strategy among these three investments.

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

The chart shows the ratio of XME (metals and mining ETF) and gold (upper panel). The real-time business cycle indicator is shown in the lower panel. This gauge is published in each issue of The Peter Dag Portfolio Strategy and Management on www.peterdag.com. An exclusive complimentary issue is available to the readers of this article.

The chart shows XME outperforms gold (the ratio is rising) during the rising phase of the business cycle as the economy strengthens. When the business cycle declines, reflecting a weakening economy, gold outperforms XME (the ratio is declining).

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

The above chart shows the ratio of XME and TLT, the ETF reflecting the price of long-term Treasury bonds (upper panel). The lower panel shows the real-time business cycle indicator.

The graphs show XME outperforming TLT (the ratio rises) when the business cycle rises because of a strengthening economy. XME underperforms TLT (the ratio declines) when the business cycle declines, indicating a weakening economy.

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

The above chart shows the ratio of gold and TLT (upper panel). The real-time business cycle indicator is shown in the lower panel.

The graphs show gold is stronger than TLT when the economy strengthens (the ratio rises), and the business cycle rises. Gold, however, is weaker than TLT (the ratio declines) when the economy weakens, and the business cycle declines.

Key takeaways

XME is stronger than gold and TLT in a rising business cycle.

Gold is stronger than TLT in a rising business cycle.

Investors should invest in XME in a rising business cycle.

TLT is stronger than XME and gold in a declining business cycle.

Investors should invest in TLT in a declining business cycle.

Gold is the worst performer in a rising or declining business cycle environment when compared to XME or TLT.

George Dagnino, PhD

Why Markets Do Not Rise On A Straight Line.

Summary

Prices are dominated by the fluctuations of the business cycle.

The business cycle causes prices to rise or decline.

Major turning points in the business cycle offer great risks and major investment opportunities.

Source: The Peter Dag Portfolio Strategy and ManagementThe turning points of a business cycle are crucial. In March 2020, for example, the business cycle transitioned from Phase 4 to Phase 1. This change favored transportation, industrials, commodity-sensitive sectors, and financials. It penalized a strategy emphasizing defensive sectors and bonds.

What are the causes of these turning points? Understanding what creates them may help to recognize the implications of the recent sharp rise in commodities, bond yields, and inflation.

Prices are driven by business decisions and the most difficult and far-reaching ones are those involved in assessing the level of production and capital investments.

The business cycle declines, reflecting a slowdown of the economy (Phase 3), because business is penalized by excessive inventories as demand for their products weakens. Profitability, as a result, suffers at that time. The decision is made to scale down operations to re-establish profitability. Profitability will be finally reached when the causes that have affected it are brought under control. This is a particularly important point useful in timing new investment opportunities.

Inventory must be brought in line with demand. Purchases of raw materials must be cut because of lower production levels. Working hours and employment are also reduced. Borrowing needs to be lowered as well because of less ambitious production and investment activity.

These decisions are made all at the same time by businesspeople all around the country. The outcome will be lower commodity prices, lower wages, lower interest rates, and lower inflation. These declines will last until they are reflected in improved profitability. This is the time managers will stop cutting production with all its implications on prices and inflation.

From a demand viewpoint, consumers are now in better shape with purchasing power increased due to the decline in inflation and interest rates. These conditions – improved profitability and increased purchasing power – cause the transition of the business cycle from Phase 4 to Phase 1.

The increased demand will force businesses to hire workers, to pay higher wages, buy raw materials, and increase borrowing. This process feeds on itself and the positive feedback will cause business to further increase production and to grow.

The strength of production efforts accompanied by rising demand will eventually cause raw material prices, energy prices, bond yields, and inflation to rise. This is the signal the economy is running above capacity and is now well into Phase 2.

Eventually, these price increases will have a negative impact on consumer behavior. Purchasing power declined as rising inflation and interest rates dampen consumer demand.

The business cycle has now reached the end of Phase 2. Business does not recognize demand is waning and keeps producing goods to replenish inventories. As demand keeps slowing down, however, rising inventories have a negative impact on earnings.

The decision is made to cut production and the business cycle moves to Phase 3.

The turning points in the business cycle signal risk and opportunities in the stock market and in the overall portfolio management. They also suggest two opposite investment strategies whether the busines cycle moves from Phase 2 to Phase 3 or from Phase 1 to Phase 2.

The reason I suggested in my article “The Bond Market Is Tightening. The Fed Is In A Box. The Economy Will Pay.” is because the current rising trend in commodities, interest rates, and inflation suggests we are in the middle of Phase 2. The only way to “ease” and bring bond yields down is an economic slowdown – the business cycle must enter Phase 3.

The following chart supplies the justification for the last point.

Source: St. Louis Fed

The above chart shows the historical pattern of short-term interest rates (blue line), 10-year Treasury bond yields (red line), and business recessions (shaded areas).

The reliable pattern is rising interest rates ahead of every business slowdown/recession. Another important pattern is interest rates decline following a period of busines slowdown/contraction. Furthermore, there is a tendency for interest rates to rise 1-2 years following the beginning of a business expansion. The cyclical pattern of inflation is like that of interest rates.

The sooner interest rates, commodities, and inflation rise following an expansion, the shorter is the business cycle. Or, to put it in another way, the length of the busines cycle depends on how soon interest rates, commodities, and inflation rise. The reason is the increase in these variables forces businesses to cut inventories thus causing the business cycle to transition from Phase 2 to Phase 3.

Source: Federal Reserve

The crucial turning point from Phase 2 to Phase 3 is also highlighted by rising credit risk. This development is clear in the above graph, showing the net percentage of lending officers tightening credit standards. A rising in the net percentage of lending officers tightening lending standards above zero percent is an important warning the busines cycle is close to Phase 3.

The current data (as of January 2021) show the net percentage of lending officers tightening lending standards is actually declining. It suggests the business cycle is in Phase 2 (as of January).

Source: StockCharts.com

The above chart shows the price trends (from top to bottom) from January 2009 to March 2021 of copper, lumber, crude oil, and 10-year Treasury bond yields. The graph in the bottom panel is the real-time business cycle indicator.

A rise in the business cycle indicator, which began in March 2020, has been accompanied by the increase in the price of copper, lumber, crude oil, and bond yields. A decline in the business cycle indicator, reflecting weaker economic growth, is accompanied by lower prices of copper, lumber, crude oil, and bond yields. The current trends can be assessed using our real-time busines cycle indicator. This indicator is updated in each issue of The Peter Dag Portfolio Strategy and Management on www.peterdag.com. A complimentary subscription is available to readers of this article.

Source: St. Louis Fed

Another development confirming the business cycle is in Phase 2 is the increase in inflation, as shown in the above chart. The chart shows the growth of the producer price index (blue line) and consumer prices (red line) are in a visible uptrend. The experience of the last 11 years shows the rise of inflation will be followed by a slowdown of the business cycle as it happened in 2011-2012, 2014-2016, and 2018-2020.

Key Takeaways

Prices do not rise on a straight line because their trend depends on the direction of the business cycle.

Commodities, inflation, and bond yields usually bottom in Phase 1 and rise in Phase 2 of the business cycle.

The business cycle will be in Phase 3 when lending officers are tightening credit standards. The business cycle is still in Phase 2 because credit risk is still low as of this writing.

Commodities, bond yields, and inflation decline when the business cycle is in Phase 3.

Stock market risk is the highest when the business cycle is in Phase 3 and Phase 4.

The stock market offers the greatest investment opportunities when the business cycle is in Phase 1 and Phase 2.

The investment strategy in Phase 1 and Phase 2 is substantially different from the investment strategy in Phase 3 and Phase 4.

George Dagnino, PhD

Silver Is A Metal. Sometimes it’s Hot, Other Times It’s Not. Timing Is Crucial.

  • Silver could be a hot precious metal.
  • But silver is also a commodity.
  • The business cycle will help you decide when to buy it.

A review of recent history may be helpful. The above chart shows silver peaked in 2011 – like gold and copper – when the economy started to slow down. It kept declining during 2012-2016 even as the economy showed visible improvements during those years. It traded in a range from 2016 to 2020. It has more than doubled since then as the economy began to grow at a faster pace.

The above chart shows the graph of silver prices divided by gold prices. Silver has been weaker than gold from 2011 to 2020 as shown by the steady decline of the ratio during this period. Since March 2020 it has displayed considerable outperformance compared to gold (see above chart).

Every time the price of a commodity or precious metals rises rapidly it raises emotions. Price targets are raised quickly, making silver even more attractive. What are the reasons for its sharp rise? Will the trend continue? Are there better alternative investments in the commodity complex?

One way to find an answer is to look at what is the primary mover of commodity prices. Often, we are too involved with the technical reasons why prices change. More often than not, however, there are fundamental reasons. Prices change because business needs raw materials to produce goods. Other times their needs are not so pressing because of lower demand expectations.

The business cycle is the crucial development driving commodity prices. The business cycle is caused by the adjustment process of inventories as they are changed to adapt to the growth of sales. Business (and miners) do not react at once to a slowdown in sales. They prefer to keep producing, expecting a comeback in demand. This decision is based on keeping unit costs of production low by using plants at close to capacity.

The first reaction to a slowdown in demand is to cut prices hoping to stimulate demand. As the slowdown becomes more pronounced, business is forced to cut production in response to bloated inventories and lower earnings. Supply, in other words, is trying to catch up with weakening demand. The inventory cycle is the main driver of commodity prices.

The decision to cut inventories causes a reduction of the raw material purchases – and commodities decline. An increase in inventories, caused by stronger demand, forces business to increase raw material purchases – and commodity prices rise. This change in purchasing strategies drives commodity prices up or down depending on whether the business cycle is strengthening or weakening.

The main issue for traders and investors is, of course, when should I buy silver? Or should I buy an alternative investment in the commodity complex? The answer is given by the following chart.

The above chart shows the ratio of the price of XME (ETF holding metal and mining stocks) and the price of silver. The lower panel shows the Business Cycle Indicator, updated regularly for subscribers of The Peter Dag Portfolio Strategy and Management available on www.peterdag.com. (A complimentary issue is available to readers of this article).

The relation between the two graphs is remarkable. It should provide an important strategic guide for investors interested in commodities and silver in particular.

The above relationship shows metals and mining stocks (XME) are likely to outperform silver (the ratio rises) when the economy grows faster as it did during 2012-2014, 2016-2018, and since March 2020.

Silver is likely to outperform metals and mining stocks (XME) (the ratio declines) when the business cycle shows the economy slowing down as it did during 2011-2012, 2014-2016, and 2018-2020.

Key takeaways

Silver has important cyclical features.

Silver becomes more attractive than XME when the economy slows down.

It becomes unattractive compared to XME when the economy strengthens as it did since March 2020.

In a stronger economic environment metals and mining stocks (XME) are considerably more attractive than silver.

XME will continue to outperform silver as long as the Business Cycle Indicator rises, reflecting a stronger economy.

The Bond Market Is Tightening. The Fed Is In A Box. The Economy Will Pay.

Summary

  • The yield curve is steepening.
  • It follows the historical script dictated by the business cycle.
  • This time it means a tightening action by the markets.
Source: St. Louis Fed

This is an incredible chart. Its implications could be particularly important for investors and strategists. It shows three yield curves measured as the difference in yields of Treasury instruments between 10-2, 5-2, and 10-5 years.

A rising curve means the spread between short-term and long-term duration instruments is increasing and the yield curve is steepening. The decline in the graphs shows the opposite – spreads are narrowing, and the yield curve is flattening.

There is another interesting pattern. The yield curve starts steepening just ahead of a recession (shaded vertical area). In more general terms, it starts steepening ahead of a period of slower growth in business activity.

The explanation requires more details especially if one wants to understand what is happening now and why the Fed has become irrelevant. It may show how its past policies have resulted in an abdication to monetary policy, leaving the tightening and easing of monetary policy to the markets.

Source: St, Louis Fed

Let me explain. First, we need to look at the historical patterns of interest rates (see above chart). Shaded areas show recessions.

The first behavior is short-term interest rates (blue line) change more rapidly than the long-term ones.

Then, interest rates peak close to the beginning of a period of slower growth in the economy, just ahead of a recession. The decline in short-term interest rates can be justified in two ways.

The business cycle was already slowing down before the peak in short-term interest rates. Business borrowing was declining as managers tried to reduce overstocked inventories. The decline in short-term interest rates was further reinforced by the easing action of the Fed as it recognized the dangers faced by the economy. The sharp increase in money supply M1 always accompanied the decline in short-term interest rates.

The decline in interest rates and the easing of the Fed helped to cushion the weakness of the business cycle. This process was discussed in detail in my article A Strong Economy And Risks For The Markets. Eventually interest rates rise again after about 1-2 years following the end of the slowdown/contraction in business activity.

The reason the yield curve steepens (see first chart) as the economy weakens is due to the relative movements of short-term and long-term interest rates. Short-term interest rates decline rapidly compared to the trend in bond yields. The action of bond yields, on the other hand, is muted by the sharp decline in short-term interest rates.

What has been happening in the past year is different from what has been happening in earlier cycles. M1 has been soaring but is not having any effect on short-term interest rates because they are zero percent. It is making the current economic and financial environment more fragile than in the past.

Source: StockCharts.com

I need one more piece of evidence discussed many times in my articles. Yields move in synchronism with the business cycle. They rise when our business cycle indicator rises, reflecting a stronger economy. Yields decline as soon as the business cycle indicator declines, reflecting the beginning of an economic slowdown. The business cycle indicator is updated in each issue of The Peter Dag Portfolio Strategy and Management on www.peterdag.com. (Complimentary issue is available to readers of this article.)

The crucial point is yields rise because they are driven by market forces and by a strengthening economy. This is what history shows.

Let’s go back now to the issue of the meaning and implications of the recent steepening of the yield curve, presented by the press as a positive sign for the markets and the economy.

The current rise in yields is a form of tightening because it is not compensated by a decline in short-term interest rates. The markets are raising the price of money. Rising prices may be a positive sign in the near term. Protracted increases tend to discourage borrowers – business and consumers.

In earlier cycles the Fed responded to an economic slowdown by encouraging the decline in short-term interest rates. It did so by aggressively increasing liquidity – M1. The steepening of the yield curve, in other words, reflected mostly the easing of the Fed.

This cycle is different, much different from the past. Yields are rising, driven by market forces, the same market forces driving the business cycle. Yields are rising and are making money more expensive.

Liquidity is plentiful. Money has been printed aggressively for more than a year. This time, however, the Fed cannot lower short-term interest rates and make money “cheaper”. This time they cannot do it because short-term interest rates are zero percent.

Yes, there is a lot of liquidity (debt). But this debt has historically had a negative impact on the growth of the economy over the long-term. (See my article: Yields, Economic Growth, And Stock Prices – A New World For Investors).

Business and consumers respond to the price of money. What they see is rising interest rates. This perception and reality are a form of tightening because it discourages borrowing. The Fed cannot do anything about it. More debt (stimulus) will not work as it did not work for several decades. (See my article quoted above).

Key takeaways

More debt (stimulus) cannot overcome the tightening caused by rising bond yields.

The business cycle is much closer to the end of Phase 2 (strong growth phase) than the beginning of Phase 1 (beginning of the expansion phase). (See my article A Strong Economy And Risks For The Markets.)

A Strong Economy And Risks For The Markets

A Strong Economy And Risks For The Markets

George Dagnino

Summary

The latest data point to a strong cycle ahead and increased risks for the markets.

The economy is strong, no doubt about it. The trend of the business cycle and financial markets reflects the current positive economic conditions. The markets are reacting as they have typically done during this phase of the business cycle.

The business cycle moves in waves because it reflects justifiable miscalculations by business managers about the desired level of inventory needed to meet expected demand. It is a complex decision biased by the continuous vociferous comments from analysts and commentators.

The bottom line for decision makers is how much to produce to meet demand through the supply chain.

Source: www.peterdag.com

Why does the economy slow down? Why does the business cycle move from Phase 2 to Phase 3? Where is the current position of the business cycle now?

These are crucial questions. Their answer drives tactical and strategic investment decisions, and it shows the risks facing the markets.

The major causes for the economy to slow down and the business cycle to transition from Phase 2 to Phase 3 are: rising commodities, rising interest rates, and rising inflation.

During Phase 2 of the business cycle managers are focused on building inventories to meet rising demand for their products. Demand is strong and production must be increased aggressively. To do so business has to purchase raw materials, hire production workers, and increase borrowing to finance the production process.

Toward the end of Phase 2 the intensity of building up inventories causes inflation and interest rates to rise to levels hindering consumers’ purchasing power and consumers’ confidence. The outcome is demand starts slowing down.

Business remains optimistic about the future and does not recognize this change in demand. They keep ramping up production to keep plants operating at full capacity. Eventually, however, inventories are rising at a much faster pace than demand, causing profitability to suffer. The inventory/sales ratio shows a visible rise.

The decision must be made to reduce production to cut inventory accumulation and bring it in line with the slower growth in demand. Purchases of raw materials are reduced. Workers are laid off. Borrowing is cut as reduced production requires cut in financing.

This process continues through Phase 3 and Phase 4. The outcome is continued weakness in commodities, lower interest rates, and lower inflation.

Eventually, at the end of Phase 4, inventories are brought in line with demand. Consumers’ optimism improves because of lower inflation and interest rates. Demand increases and business is forced to increase production accordingly. Phase 1 is now under way.

In order to increase production business raises purchases of raw materials, hires more production workers causing income to improve, and increases borrowing to finance production. These events feed on themselves throughout Phase 1 and Phase 2.

Where are we now? Recent data about the inventory to sales ratio published every month by the Census (see chart below) help us to answer this question.

A rise in the I/S ratio means inventories are rising more rapidly than sales. This is a bearish sign for the economy because business will be forced to cut production to lower inventory accumulation and bring inventories in line with the slowdown in demand. This process and its impact on the markets have been discussed in detail in my article The Inventory Cycle – Boring But Important Market Setter. An in-depth report showing what happens during a complete business cycle is also available to visitors of www.peterdag.com.

The above graph shows the I/S ratio started to decline sharply in early 2020. It signaled business was heavily understocked compared to demand. Inventories were reduced too aggressively.

Source: Federal Reserve of St. Louis

The outcome, as shown in the above chart, has been a sharp rebound in production (blue line) and manufacturing employment (red line), reflecting the business decision to increase production to replenish inventories.

Source: StockCharts.com

Because of increased production, as shown on the above chart, yields, copper, lumber, and crude oil all moved higher. Exactly as it is supposed to happen in Phase 2 of the business cycle.

REAL-TIME BUSINESS CYCLE INDICATOR

Source: StockCharts.com

The above chart shows the graph of the business cycle. Its trend is computed in real-time and updated in each issue of The Peter Dag Portfolio Strategy and Management (a complimentary subscription is available to the readers of this article on www.peterdag.com).

The current rising trend of the graph shows the business cycle is still improving. The recent sharp increase in inflation, commodities, and long-term interest rates suggests we are much closer to the end of Phase 2 than the beginning of Phase 1.

As long as the I/S ratio declines and our business cycle indicator rises, the trends of the markets shown in a previous chart will continue to rise. They will reverse when the business cycle starts to slow down. This is the time the I/S is likely to bottom and move higher. Its increase will reflect an unwanted accumulation of inventories which will be followed by production cuts.

These trends will signal the business cycle is entering Phase 3 and the outcome will be a decline in commodities and interest rates.

Key takeaways

The current decline in the I/S ratio is forcing business to increase production.

Copper, lumber, crude oil, and bond yields are rising because of the increased production needed to build up inventories as manufacturers try to catch up with demand.

The sharp increase in commodities and interest rates suggests the business cycle is much closer to the end of Phase 2 than the beginning of Phase 1.

The transition from Phase 2 to Phase 3 will be accompanied by a peak in yields and commodities and increased equity market volatility. A prolonged market correction should be expected at that time.

Date: 3/19/2021

As published on TALKMARKETS

Gold Is A Precious Metal, Other Times Not So Much – The Business Cycle Helps You Decide. (Part 2)

Summary

  • Gold is a precious metal.
  • Sometimes it acts as a metal.
  • This model helps you decide when to invest in it.

Throughout the centuries gold has been the premier investment to protect a portfolio from the ravages of inflation. For this reason, it has been historically considered a store of value.

Source: StockCharts.com

There are times, however, when gold prices suffer a prolonged decline. The above chart shows gold prices going from 2007 to March 2020. Gold moved from $600 to $1,900 from 2007 to 2012. It stands below $1,700 as of this writing (March 17, 2021). Gold did not show any appreciation for more than 9 years. This performance challenges the concept of gold as a store of value.

Source: StockCharts.com

The concept of store of values is further challenged by the performance of gold compared to the S&P 500. The above chart shows the relative performance computed as the ratio of gold prices to SPY. The decline in the lines in the graph says SPY has outperformed gold from 2012 to 2020. Gold has outperformed SPY – the lines in the graph were rising – from 2009 to 2012.

The point I am trying to make is investing in gold is not as easy as reported by the passionate and often biased sponsors of the metal. And it does not necessarily outperform the S&P 500 all the times. Gold, however, has an interesting and possibly profitable pattern when compared to other metals.

There are times gold is a good investment. Other times investors should accept the idea it is not. Gold is a commodity – a metal. In the article mentioned above I showed how the price of gold has some distinguishable cyclical and profitable patterns when compared to other metals.

The business cycle drives the investment opportunity in gold and greatly improves the returns of an investment portfolio. The busines cycle drives the timing of the strategy. The business cycle is the outcome of business decisions focused on meeting demand for their goods. To do so, manufacturers must make sure there is enough inventory to meet the demand for their products.

When demand is improving business must purchase raw materials, hire workers, and increase borrowing to organize the process of producing more goods. The increased income is followed by higher demand which forces business to increase the purchases of raw materials, to hire more workers, and raising more capital. This positive feedback eventually places upward pressure on commodities, wages, and interest rates.

There is a point when this positive momentum of the business cycle is reversed. The strong economy forces inflation to rise and reduces consumers’ purchasing power. At first business managers do not recognize the business cycle has peaked and continue to ramp up production.

Eventually inventories are too high, and they begin to affect profits. This is the time when production is cut. Purchases of raw materials are slashed, workers are laid off, and borrowing is reduced. The busines cycle slows down until inventories are brought in line with sales and profitability stabilizes. In the meantime, commodity prices decline, wages slow down, interest rates head lower, and inflation subsides.

This is the time when purchasing power improves and consumers’ demand rises. Managers are forced to increase production to replenish inventories and the business cycle starts all over again.

During the phase of the business cycle investors should expect rising commodities, rising inflation, and rising interest rates. During the slowdown phase of the busines cycle commodities, inflation, and yields decline.

Source: StockCharts.com

The above chart shows in the upper panel the price of the metals and mining ETF (XME) with its 200-day moving average. The lower panel shows the busines cycle indicator as updated in each issue of The Peter Dag Portfolio Strategy and Management (a complementary subscription is available to readers of this article on www.peterdag.com).

As discussed in detail in my article “The Inventory Cycle – Boring But Important Market Setter,” the main reason for this relationship is commodities depend on the purchasing activity of raw materials as business attempts to control inventory levels in a rising or weakening economic environment.

The relationship between XME and the busines cycle indicator reflects the strengthening of the economy and the decisions of business managers to replenish inventories. Commodity prices rise or decline depending on whether the business cycle rises or declines. For this reason, XME, a commodity sensitive ETF, rises when the business cycle indicator rises. XME declines when the business cycle indicator declines.

What is particularly interesting is when gold is compared to other metals it has very specific turning points closely related to the turning points of the business cycle indicator.

My article published on 12/23/2020 showed XME outperforms gold when the business cycle rises and the economy strengthens. What has been happening since then has followed the historical pattern.

Source: StockCharts.com

This approach tells you whether you should own gold or XME – a basket of metals and mining stocks.

The above chart shows a remarkably interesting pattern. The upper panel shows the ratio XME to gold prices. The lower panel shows our real-time business cycle indicator.

The relationship between the two sets of indicators suggests investors should buy XME when the economy strengthens, and our business cycle indicator rises. The reason is the rising line reflecting the ratio XME/Gold is moving up. Note how XME has outperformed gold since early 2020 when the business cycle started rising.

Gold, however, outperforms XME as a defensive play when the economy slows down and our business cycle indicator declines. During such times, the ratio XME/Gold declines reflecting the weakness of XME relative to gold prices.

Key takeaways

Gold has cyclical patterns which become clear when its price is compared to the price of other metal commodities.

Gold, furthermore, is particularly attractive compared to other commodities when the economy slows down.

The model published on 12/23/2020 correctly suggested XME would outperform gold as long as the business cycle rises, reflecting a strengthening economy.