The Business Cycle and Sector Rotation, Part 1

November 24, 2008

 

Over the weekend, I read a book called Intermarket Analysis, by John Murphy.  Mr. Murphy is an industry veteran and is well-respected in the fields of Technical Analysis and intermarket relationships.  I found this particular work fascinating from the standpoint of how we must not only study the stock market, but also keep in mind bonds, currencies and commodities, and their influence on equities.  The general ideas in the book were not new to me, but his clear analysis of recent events (up to 2004 when the book was published), offers a wealth of information in understanding our current situation.  
 

In this two-part series, I would first like to present the basics of Intermarket Analysis and the business cycle.  I'll cover sector strengths and weaknesses during typical cycles, and discuss how things like interest rates, commodity prices, and dollar strength contribute to this cyclicality. 

 

In Part 2, I'll use the tools developed here to determine where our current situation fits into the overall business cycle, and which stock groups are likely to do well.  Finally, I'll present some ideas about what to look for in order to have some confidence that a recovery in equities is likely, and it may be safe to jump back in the water.

 
All graphics in Part I come from Murphy's book, but all analysis and commentary are my own.
 
Market Cycle vs. Business Cycle

First off, a quick definition.  You may have heard that the market anticipates the economy by about 6 months.  The reason is that 6 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 judgements on is somewhat lagging.

 

Regardless, market participants are always putting their money where they think conditions will lead us up to a half-year out.  For this reason, the market cycle will generally precede the true business, or economic, cycle by approximately that same amount of time.  I go into more detail on this topic below.

 

The Benchmark Business Cycle

Figure 1 shows the theoretical, or predicted, typical business cycle.  According to the designer of this diagram, Martin Pring, the cycle consists of six separate steps:

 

Figure 1

Inter-market Relationships in the Economic Cycle
 

 

Stage I:  The initial slowdown in business activity causes a reduction in demand for debt.  This brings interest rates down (bonds up), as equities and commodities continue their downward moves (from previous stages).  Commodities, a very cycle-sensitive group, are not in great demand, and inflation is typically not a concern.  Deflation, however, may be.

 

Stage II:  At the bottom of the recession, traders will anticipate the recovery, and start to buy stocks;  the next bull market begins.  There are not many plans yet by businesses for large capital expansions, so debt demand is still low, keeping interest rates low.  Rates are also kept low to spur consumer spending.  Commodities continue to be out of favor, as business activity (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 metals, oil, etc. builds.  Stocks continue their bullish bent.

 

Stage IV:  Commodities continue to rise with stocks as demand in both the industrial and consumer sector is strong.  Financing/growth in corporations is in demand, so bond prices come down as interest rates go up.  The yield curve could become inverted as demand for short term funding is strong.

 

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 remain in tact, but equities begin to level off.  Unfortunately, this is usually around the same time that most uninformed investors get into the market, the so called “small money”. 

 

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

 

 

Sector Rotation in the Business Cycle

Turning to stock groups now, Figure 2 shows a graphical view of the expanding and contracting business cycle.  Sectors that typically do well during these periods are shown inside the circle.  Why does this rotation take place?  Let’s look at each group in the context of it’s place in the cycle.

 

Figure 2

Sector Rotation within the Economic Cycle
 

 

 

Consumer Staples (Stages VI & I)

As soon as traders and investors get even a hint of a slowing economy, they will start to rotate money out of cyclical names and into 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.  Consumer staples companies are typically stable, non-volatile stocks like Procter & Gamble, Lever Brothers, and Johnson & Johnson.

 

Utilities (Stages I & II)

In early contraction, interest rates are moving down (bonds up).  Utilities fund a large 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 in the stock.  As treasury rates drop, the dividends of utilities makes them attractive in comparision 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 considered a safe place to hide your money.

 

Financials (Stages II & III)

The late contraction phases are typically supported by low interest rates.  Rates are kept low to spur spending during an otherwise difficult period.  Financial stocks benefit from the low rates as their cost of capital is lower, similar to utilities.  Banks can borrow more cheaply, and can potentially expand their margins as long as 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 stocks have been beaten down in the recession, and the strong ones will look very attractive from a valuation standpoint. 

 

Cyclicals typically include housing (furniture, carpeting, construction, appliances, etc.), 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 buying technology.  They replace outdated equipment with new technology.  Software is updated.  Consumers begin to buy the newest cell phones and computers, since by now rising unemployment is behind them, and a new expansion in the economy is taking place.

 

Transportation (Stage IV)

All these newly produced goods and services must be moved around.  Railroads, shipping, trucking and even airlines tend to do well during this expansion phase of the business cycle.  Everything from raw materials (commodities) to intermediate goods, to final goods are in demand and need to be moved.

 

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 necessary.  Heavy equipment will be bought or rented for large scale construction projects in real-estate, warehousing, commercial office spaces, and shopping malls.  The prosperity in this phase also gives governments the tax revenues to build out infrastructure. 

 

Basic Materials (Stages IV & V)

As we just witnessed over the past couple of years, basic materials become in great demand with all the manufacturing and construction work during Stages IV and V.  Copper for homes, steel for buildings, chemicals for agriculture…the companies who produce these items generally show excellent 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 reality, the industrial demand for oil is assumed to shrink very quickly, and can cause an abrupt drop in the crude futures.

 

Putting It All Together

Figure 3 is another graphic from Mr. Murphy’s book.  I like it because it conveys a lot of information in a concise space. 

 

Figure 3

Stock Market vs. Economic Cycle

 
 
Note the following:
  • The market cycle precedes the economic cycle.
  • Different goups do better during bull markets than during late-stage economic recovery.
  • There is a certain amount of contrarianism at play here when deciding which sectors to invest in.  For instance, during a full-on recession, you should be preparing your wish list with names in cyclicals and technology.  This seems counter-intuitive, but the markets are always about anticipation.  If you wait for tech companies to deliver good earnings, for instance, traders will have already been buying the good names in anticipation of those earnings. 
  • The in-favor sectors overlap, and there is no guarantee that this exact order will take place every cycle.  In general, though, for the reasons noted above, this is your best guideline for choosing sectors.

Conclusion

Knowing where we are in the market cycle as well as the economic cycle is critical to success in the stock market.  We want to be in the sectors which have the greatest chance of positive returns given the macro conditions.  Not only does this approach increase our odds of success, but it narrows down our playing field of potential stocks or mutual funds.  If you do you homework on market and business cycles before your next investment, you will have greatly helped yourself reach your goals. 
 

This brief discussion on Intermarket Analysis and Sector Rotation was meant to prepare us for the analysis of our current conditions.  I will follow up with another Market Brief tomorrow, in Part 2, and tell you what I think we need to look for to anticipate, and profit from, the next phase of the cycle.

 

Dan Grill

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