“I believe that Dan Grill is one of the best multi-strategy derivative traders on the planet. It is not a coincidence that he leads off the Wilshire Phoenix Series of Industry Experts who will be providing powerful insight into the global markets on a regular basis. I am so incredibly grateful and humbled to have Dan as a contributor.”
– William Herrmann, Founder and CEO of Wilshire Phoenix
By Contributing Author, Dan Grill with William Herrmann
In this two-part series, I would first like to present the basics of intermarket analysis and business cycles. I will cover sector strengths and weaknesses during typical cycles, and discuss how items such as interest rates, commodity prices, and dollar strength contribute to this cyclicality. In Part 2, I will use the tools developed here to determine where our current situation fits into the overall business cycle, and which sectors are likely to do well. Finally, I will present some ideas about what to look for in the months ahead.
I would like to point out that the below does not fully represent current market conditions. It is to lay a foundation of understanding for Part II. At such time, I will address the trade skirmish, among other scenarios. For instance, if the skirmish were to evolve into a full-blown trade war – all bets are off.
Market Cycle vs. Business Cycle?
You may have heard that the market anticipates the economy by about six months. The reason for that is six months is about as far as traders can reliably guess given current economic data. Also contributing to the short-term predictability is the fact that most of the economic data we base our judgments on are lagging. Regardless, market participants are always putting their money where they think conditions will lead us up to about a half-year out. For this reason, the market cycle will typically 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 “typically” brings 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 stocks; the next bull market begins (to add some perspective, this would have been March 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 finally join the party as demand for industrial materials builds. Stocks continue their bullish run.
Stage IV: Commodities continue to rise with stocks as demand in both the industrial and consumer sector is strong. Most corporations are typically issuing more debt (high-yielding, see $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 for longer duration (see $TLT and $TBT).
Stage V: Just when everything seems to be going well for the economy, the stock market tops out. The previous trends in bonds and commodities may remain intact, but equities begin to level off.
“I believe we are currently close to the end of Stage V – while there is a bid still for commodities, institutions, are not participating in a meaningful manner, investors are chasing – that’s not sustainable. The so-called “smart money” is selling into strength, but that strength, for lack of the better word is synthetic. To be clear, this is not my opinion and is evident by low overall volume on up days and high volume on down days (using any of the major averages such as the DJIA and SPX or by their popular derivative ETFs as a guide, the DIA or SPY, respectively). There is much noise in the equity markets, and in all markets for that matter, but it is as clear of a signal that any retail investor will ever receive; this is extremely powerful information,” say’s Herrmann.
Source: StocksChart.com A/O 10/9/18
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. Stocks continue to price in lower future earnings, again on recession fears.
Intermarket Relationships in the Market Cycle
Why does this rotation take place? Let us look at each group in the context of its place in the cycle.
Consumer Staples (Stages VI & I): As soon as traders get even a hint of a slowing economy, they will start to rotate money out of cyclical names and into consumer staples. These companies make diapers, paper towels, medicine, peanut butter, soap, 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 not staples. As an example, consumer staple companies are typically non-volatile and low beta, such as Procter & Gamble and Johnson & Johnson.
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. Furthermore, most utilities pay a significant 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 stocks in the cyclical groups. Finally, utilities are considered to be non-cyclical by nature. We still use electricity, even if we cut back on other expenses. As the economy enters into a contraction phase, utilities are generally considered “safe”.
Financials (Stages II & III): The late contraction phases are typically supported by a low-interest rate environment. Rates are kept low to spur spending during an otherwise difficult period. Financial stocks benefit low rates as their cost of capital is more moderate, similar to utilities. Banks can borrow more cheaply and can potentially expand their margins as long if they continue to loan. Keyword is “if”.
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 stocks have been beaten down in the recession, and the strong ones will look attractive from a valuation standpoint. Cyclicals typically include housing, furniture, carpeting, construction, “Amazon Prime Addiction”, automobiles, electronics, and other purchases that businesses and consumers have put off during the recession. Commodities will start to turn up at this point to support the growing demand for cyclical manufacturing.
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 may be updated (for instance, NVDA, AMD, INTC, MSFT and so on). As to consumers they now begin to buy, say the latest iPhone, since rising unemployment is over and new expansion in the economy is taking place.
Transportation (Stage IV): All these newly produced goods and services must be now be moved around the world. Railroads, shipping, trucking, and airlines tend to do 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 globally.
Capital Goods (Stages IV & V): As the good times continue, companies will expand operations to meet the rising demand. Capital goods such as cranes and oil rigs become increasingly needed. Heavy equipment will be bought or rented for large-scale construction projects.
Basic Materials (Stages IV & V): Necessary materials are now in high demand. This 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 who produce these items show great earnings at this time.
Energy (Stages V & VI): In the last hurrah for commodities, oil prices tend to spike up just before a recession. 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 the crude futures.
Knowing where we are in the market cycle as well as the economic or business cycle is critical to success in the stock market.
We want to be in the sectors which provide us the highest probability of positive returns given the macro conditions. Not only does this approach increase our odds of success, but it narrows down the playing field of potential stocks and/or funds. If you do your homework on market and business cycles before your next investment, you will have significantly helped yourself reach your goals.
I will follow with another Market Brief, in Part 2, and tell you what I think we need to look to anticipate, and thus ultimately profit from, in the next phase of the current cycle.
The tireless work of John Murphy has inspired this piece. If you found this helpful, the book, Intermarket Analysis, by John Murphy is an absolute must read.
ABOUT THE AUTHOR
Dan Grill is an independent trader with a background in engineering and computer programming, He has traded the markets since 1998 and focuses on technical analysis, momentum trading, and option strategies.
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