Thursday, April 10, 2014

A little foray into cycles past...

Along with the recent volatility has come more talk/prediction that the stock market is in for some real pain ahead. The "experts" who've been calling for the end of the bull market see this year's changing leadership among sectors as one strong indicator that supports their position: Last year's winners have thus far been this year's losers, while last year's losers (smallest gainers) are leading the pack this year. And I'll further bolster their case by pointing out that not only has leadership, for the moment, changed, this year's leader, utilities, tends to be a late-cycle out-performer. Plus, the narrowing (in terms of sectors) of the rally---while all 10 major sectors advanced in 2013, only 4 are in the green thus far in 2014---is another classic sign of a tiring bull market.

Not to suggest that they're wrong---again, some of the above is my own observation---but of course we know it's never that easy.

Here's the general logic (and basic history) around economic and market cycles. And, in italics, my comparisons to the present. Keep in mind, each new cycle is always a little (or a lot) different than previous ones.

Early stage recoveries are generally characterized by falling interest rates, low inflation, weak commodities prices, rising bond prices (goes with falling interest rates)---and rising stock prices in anticipation of economic and earnings growth. That perfectly describes the early days of the present bull market.

As we get further away from the previous trough, bonds begin to exhibit more volatility, stocks moderate, and stock market corrections gain in frequency. As the bull market continues, fewer industry groups advance while industrial production picks up and the business recovery accelerates.
2013 indeed saw bond prices declining, however, stocks had an epic year. And we've yet to experience what I'd call a "correction"---these small 2-5% pullbacks should not be considered corrections. So far this year, fewer industry groups are indeed advancing (as I suggested above) and industrial production has picked up a bit of late. However, I don't know that I'd just yet hang my hat on an overall accelerating business recovery.

As we get deep into recovery, commodities prices begin to rise. The Fed begins fretting over inflation---as opposed to trying to stimulate business and job growth. Interest rates begin to rise, and, therefore, bonds begin to tank as the Fed begins the tightening process. The stock market shows signs of weakness and becomes more selective (the advance, in terms of number of gainers, narrows further)---despite the fact that business conditions tend to show continued improvement during this topping process.
In terms of commodities prices, it's been a mixed picture. And, clearly, the Fed has yet to fret over inflation. They've been very careful to signal that they'll remain accommodative (keeping short-term interest rates very low) well into the foreseeable future. Stimulating business and job growth remain their stated priorities. And while market leadership has narrowed, having staged no legitimate correction in quite some time, it's too soon to commit to the notion that it's showing discernible signs of weakness. And, keep in mind, your typical bull market is riddled, off and on, by 10-20% corrections---I, for one, would welcome a "discernible sign of weakness" (by way of a real correction) right about now.

As we get really deep into recovery, capacity utilization (the ability of companies to meet demand) gets pushed to its limit. Commodities prices are rising as capacity is stretched, demand is growing faster than supply, and inflation becomes a serious threat---which sends the Fed scrambling to contain it. Interest rates rise sharply and the high cost of money begins doing a number on the economy. Bonds of course are in a full-fledged bear market at this point. And while earnings may be holding up, stock prices, particularly those of the bull-market's biggest gainers, wane.
Well, clearly, economically speaking, we ain't there yet. In fact, we continue to see a fair amount of slack in the economy. Slack is the word that describes to what extent economic activity can accelerate without creating high levels of inflation. Capacity utilization, overall, has remained between 78 and 79 percent since the beginning of 2013 (78.1% early 2013, 78.8% currently). A push above 80 should get the Fed's attention. And the Fed isn't seeing employment costs increasing at anywhere near a threatening pace. Again, they remain ultimately concerned with the present lack of job growth---as opposed to labor costs pushing inflation higher anytime soon.

The beginning of the end: Consumers begin spending less on big ticket items, real estate prices fall against rising interest rates and commodities prices peak. Many investors (particularly retail investors), influenced by their perception---and the pleas of perma-bulls---that the economy remains healthy, buy dips that, alas, don't undip.
There's little out there that would signal we're approaching this stage just yet.

Now, all that said, never forget that it's the stock market's job to anticipate. Could it be that this year's rotation of leadership and narrowing (in terms of advancing sectors) is the market's way of telling us that an acceleration of business, quickly leading to stretched capacity, full employment, rising inflation, spiking interest rates, a restrictive Fed, etc. (all those indicators that suggest the economy is peaking), is close at hand? Could be. But that would be a lot going on over what would have to be a very short period of time. Or, is it telling us that this time is different: that, in the face of palpable uncertainty spawned by policymakers, the economy will, in effect, hurdle the phase where business accelerates, capacity wanes and inflation takes hold, and move right into the next down cycle? Could be. But, well, I'll just say "could be". Or, is it signaling another 2011: when the bull market took a pause---as utilities and staples (those defensive sectors) gained and offered hope to those betting on a bear market---only to resume its ascent into 2014? Time will tell...

Lastly, and most importantly, I want to be very careful here. While this little foray into cycles past may calm your nerves a bit, it in no way should be viewed as assurance that the next bear market isn't indeed lurking around the next corner. It's just me broadening out one side of the current market narrative. For every assertion I made above, there is a plethora of datapoints that could no doubt throw cold water all over this notion that the economy has more work to do before the market begins truly topping out (in fact, I just looked at one [the spread between the 10 yr treasury and the 10 yr German bund] that, according to historical relationships, could be signaling that the next doozy of a bear market is coming to visit in the not too distant future). It's a big world out there and, as I've stressed here time and time again, the factors that influence the global economy are uncountable and, therefore, impossible to gauge (please read again this short article). The picture I painted above is nothing more than a look in the rearview mirror. The future, I promise you, will---to a large or small degree---be different. Which is why I can't stress enough that investing sanity, in my view, can only come to those who understand that the stock market in the near-term is forever a precarious place---and who, therefore, think only long-term when it comes to the equity portion of their portfolio.


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  1. […] (how much production can factories handle before expanding and/or raising prices?), which I’ve written about before is another important stat to track as […]