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

Summary

A sound investment strategy takes advantage of the economic environment.

The economic environment drives the relative performance of investments.

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

The main forces driving the business cycle

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

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

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

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

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

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

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

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

Where are we now?

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

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

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

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

Economic growth drives sectors’ performance

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

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

High-beta and low volatility stocks respond to economic forces

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

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

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

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

Key takeaways

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

IYT: Portfolio Adjustments Are Positives in View of Supply Chain Realities but Wait for a Suitable Point of Entry

Some will remember the dozens of container ships bottlenecked off the ports of Los Angeles in the United States back in September 2021 right in the middle of the post-Covid economic recovery. A record number of freighters (more than 70) waited up to several weeks to unload their cargo in Los Angeles and Long Beach.

For its part, China, one of America’s top trading partners, was also in a critical situation in terms of maritime transport with 242 container ships waiting for a berth throughout the country, including many anchored off Shanghai and Ningbo, ready for loading goods. This was all due to a giant traffic jam due to large export volumes, as well as disruption by a typhoon and the pandemic. This period coincided with the iShares Transportation Average ETF (IYT) which invests in leading US companies operating in the transportation sector hitting a low of $240.

Source: Trading View

While some of the side effects of the supply crunch could last till Q4-2022, there has been an improvement as U.S. retailers have adapted, namely by sourcing items from different locations, one of these being Vietnam. This South Asian country which has a large manufacturing base producing a large number of items sold in the U.S. started to ease restrictions in early October, after experiencing a surge in infection rates in Q2-2021. Thus, IYT started to rise till it reached the $280 record level, and is now at $275.

Now, in addition to transportation, IYT also includes airlines as well as railroad and trucking firms. The ETF comprised 50 stocks on Dec 31, up from 47 at the beginning of the month, and tracks the investment results of the S&P Transportation Select Industry Index, which is up about 33.53% in 2021.

Going deeper, railroads get the highest share in the fund, at 31.78%, down from 34.97% at the beginning of the month. Exposure to trucking has also been slightly reduced.

https://static.seekingalpha.com/uploads/2022/1/2/49663886-16411829123651216.png

Source: iShares.com

This reduction of exposure to railroads is a positive in light of recent data from Tradeshift which point to some uncertainty in the supply chain (measured by invoice numbers) after global order volumes fell by 24 points in Q3 2021. This was “the biggest quarterly drop since the first lockdowns in early 2020”. Additionally, increase in the percentage assets held for Union Pacific (NYSE:UNP) from 17.82% (in early December) to 18.08% is another positive as after cutting the forecast for 2021 volume growth, due to supply chain disruptions hitting shipments, the company remains optimistic about this year’s overall volumes, projecting its growth “ahead of industrial production”.

Exploring further, the fund has increased the weight of the Air Freight and Logistics sector to 30.08%, up from 27.82% (early December), while exposure to Airlines has been increased from 13.49% to 14.23%. These increases should help the fund in light of a timid recovery of commercial passenger flights, as well as the continuing “boom” in air cargo, which should continue to deliver strong pandemic-induced growth, its strongest since 2017.

These portfolio adjustments, aimed at addressing new supply chain realities are a key factor that makes IYT as an ETF, a better choice than owning individual transportation stocks. In return, iShares charges an expense ratio of 0.40%, but this is compensated by dividends at a yield of 0.63% (30-Day SEC Yield). Another peer, the SPDR S&P Transportation ETF (XTN) comes at a slightly lower expense ratio, but I like IYT price-performance improvement since it moved away from the Dow Jones Transportation Average Index on July 19.

Finally, with the leading 10 names comprising more than 73% of net assets as at Dec 31, IYT comes with more concentration risks which explain its high degree of volatility. Thus, the first part of 2022 should be highly volatile as the markets are injected with a dose of realism after the Santa Claus rally. The share price may fall to the $260 level, constituting an opportunity to buy.

The iShares U.S. Transportation ETF (IYT) Could Reach $300 After Recent Rally

The iShares U.S. Transportation ETF (IYT) has added more than 26% to its value since the start of the year and could reach $300 before the end of 2021.

IYT is Up by 26% YTD

The iShares U.S. Transportation ETF (IYT) is a passively managed exchange-traded fund that has been around since 2003. The fund is sponsored by Blackrock and has nearly $2 billion in assets under management. Hence, making it one of the biggest funds seeking to match the performance of the Industrials – Transportation/Shipping segment of the stock market.

Before fees and expenses, IYT is designed to match the performance of the Dow Jones Transportation Average Index. This index measures the performance of companies operating with the Industrial Transportation, Airline and General Industrial Services industries of the United States stock market.

At the time of writing, IYT has an annual operating expense of 0.4%, similar to other funds operating within this space. Its 12-month trailing dividend yield of 0.72% is also similar to what is obtainable within the sector. IYT currently has the heaviest allocation in the Industrials sector–roughly 100% of the portfolio.

IYT ETF chart. Source: FXEMPIRE

IYT Could Reach $300 Soon

IYTs has been performing excellently in recent weeks and could maintain this till the end of the year. At press time, the ETF is trading at $278 per share, down by 0.32% since the U.S. market opened a few hours ago.

Since the start of the year, IYT has added about 29.84% and is up about 33.94% in the past 52 weeks. During this period, the ETF has traded between $208.84 and $279.33. IYT has a beta of 1.22 and a standard deviation of 27.89 for the past three years. This makes it a high-risk fund in the U.S. transport market space.

IYT has exposure to 24 companies operating in the U.S. transportation industry. Its biggest holding is Fedex Corp (FDX), accounting for about 12.47% of total assets. Some of the other biggest holders include Kansas City Southern (KSU) and Norfolk Southern Corp (NSC).