Stock Market Forecasting

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