Authored by Dan Grill and William Herrmann

You may have heard that market participants try to anticipate the economy by about six months. The reasoning for this? Six months is about as far as traders can reasonably attempt to predict future economic conditions. Also contributing to the short-term predictability is that most economic data is lagging.

Regardless, market participants are typically investing where they think conditions will lead us up to about a half-year out. For this reason, the market cycle will usually precede the actual business cycle by approximately that same amount of time.

Intermarket Relationships in the Economic Cycle

Stage I: The first slowdown in business activity causes a reduction in demand for debt. This slowdown has historically brought interest rates down (bonds prices move inverse to rates), as equities and commodities continue their downward moves. Commodities, a very cycle-sensitive group, are not in high demand, and inflation is typically not a concern.

Stage II: At the bottom of the recession, traders will anticipate the recovery and start to buy equities; the next bull market begins (to add some perspective, the most recent, and still ongoing started in March of 2009).

However, there are typically few plans yet by businesses for capital expansions, so debt demand is still low, thus keeping interest rates low. Rates are also kept low to spur consumer spending. Commodities continue to be out of favor, as business activity (in the economic cycle), is at its lowest point.

Stage III: As the economy swings out of contraction and toward growth, commodities typically begin to show strength as demand for industrial materials builds. Equities continue their bullish run.

Stage IV: Commodities continue to rise with equities as demand in both the industrial and consumer sector is strong. Most corporations are typically issuing more debt (see NYSE: HYG), so bond prices come down as interest rates move up. The yield curve could become inverted as demand for short-term funding grows, and the opposite is typical for the long end of the curve (see NYSE: TLT).

Stage V: Just when everything seems to be going well for the economy, the equity market tops out. The previous trends in bonds and commodities may remain intact, but equities begin to level off.

Stage VI: In the final act of the cycle, demand for commodities trails off as recession fears begin to build. Oil, steel, aluminum, and other cycle-sensitive industrial goods fall in price. Equities continue to price in lower future earnings, again on recession fears.

Intermarket Relationships in the Market Cycle

Consumer Staples (Stages VI & I): As soon as traders get even a hint of a slowing economy, they likely will begin to rotate money out of cyclical names and into consumer staples. These companies make paper towels, medicine, peanut butter, and shampoo, among many other things. As unemployment starts to rise during the start of a downturn, affected families will cut back on unnecessary expenses, but typically not staples. As an example, consumer staple companies generally are non-volatile and low beta, such as Procter & Gamble (NYSE: PG) and Johnson & Johnson (NYSE: JNJ).

One of the better, low-cost Exchange-Traded Funds (ETFs) to obtain exposure to Consumer Staples, in our view, is NYSE: XLP.

Utilities (Stages I & II): In the early contraction, interest rates are moving down (bonds up). Utilities fund a substantial portion of their business by issuing bonds. These bonds must compete with Treasuries to provide a competitive interest rate. If general interest rates are dropping, then the cost of capital for utilities is also falling.

Further, most utilities typically pay a sizeable dividend to compensate for the general lack of capital growth. As Treasury rates drop, the dividends and relative stability of utility companies make them attractive in comparison to bonds and falling equities in the cyclical groups.

One convenient and straightforward ETF to obtain exposure to Utilities, in our view, is NYSE: XLU.

Financials (Stages II & III): A low-interest rate environment typically supports the late contraction phases. Rates are kept low to spur spending during an otherwise difficult period. Financials usually benefit from low rates as their cost of capital is typically more moderate, similar to utilities. Banks can borrow more cheaply and can potentially expand their margins as long if they continue to loan.

Consumer Cyclicals (Stages III & IV): Toward the end of the contraction phase, and into the new expansion, investors will look forward to cyclical names. These equities have been beaten down in the recession, and the strong ones will probably look quite attractive from a valuation standpoint. Cyclicals typically include housing, furniture, carpeting, construction, automobiles, electronics, and other purchases that businesses and consumers have put off during the recession. Empty Amazon boxes are likely now all-around your home once again.

One of the better, low-cost ETFs to obtain exposure to Consumer Cyclicals, in our view, is NYSE: XLY.

Commodities may also start to turn up at this point to support the growing demand for cyclical manufacturing. The commodity of interest typically at this stage is oil, and one convenient way to access the market, in our view, is NYSE: USO.

Technology (Stages III & IV): As companies begin to invest in their own business (driving interest rates up and bonds down), they are now buying innovative technology to replace their outdated equipment. For instance, processing power is likely updated; some companies (or tickers) of note would be NVDA, AMD, INTC, and MU.

As to consumers, they begin to buy, say the latest iPhone, because employment is now stable and new expansion in the economy is taking place.

Transportation (Stage IV): Newly produced goods have now begun to be shipped around the globe. Railroads, shipping, trucking, and airlines tend to do quite well during this expansion phase of the business cycle. Everything from raw materials (commodities) to intermediate goods, to final products, are in demand and thus need to be transported.

Capital Goods (Stages IV & V): As the good times continue, companies will typically expand operations to meet the rising demand. Capital goods, such as cranes and oil rigs, become increasingly needed. Heavy equipment will also be purchased or rented for large-scale construction projects.

Basic Materials (Stages IV & V): Necessary materials are now in high demand. This demand is due to all the new manufacturing and construction work during Stages IV and V. For instance, steel for buildings, chemicals for agriculture. The companies that produce these items will likely show good earnings at this time.

One of the better, low-cost ETFs to obtain exposure to Basic Materials, in our view, is NYSE: XLB.

Energy (Stages V & VI): In the last hurrah for commodities, oil prices tend to spike up just before a recession. Then, as fears of recession start to become a reality, the industrial demand for oil is assumed to shrink very quickly and can cause an abrupt drop in crude futures.

We believe investors should seek to be in the sectors which provide the highest probability of positive returns given the macro conditions. Not only does this approach increase one’s likelihood of success, but it narrows down the playing field of potential equities or other investment vehicles.

The key message: knowing the market cycle, as well as the economic or business cycle, is critical to success in the equity market.

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