We are currently in Stage 5 of the Business Cycle.
Economists use numerous regularly released surveys, statistics
and reports to try and predict the future direction of the
economy. But if you wish to use phases of the economy to help
guide your investment strategy, perhaps the most reliable
and most available parameters are the financial markets themselves.
Asset prices tend to incorporate the markets best guess of
future events and anticipate movements in the economy. Stock
prices tend to lead an economic recession by about six months,
and an economic expansion by about four months. The business
cycle is not and exact science and is best used as a confirmation
to what you see in price. For example if we are in stage one
and high yield bonds and financials are trending up you might
want to participate in those sectors. Or if we are in stage
five and stocks are bullish, which is contrary to what the
business cycle anticipates, it might be wise not to use leverage.
Please visit this link for a full explanation of the business
cycle and its various stages.
Below is a snap shot of the most recent business cycle. Bonds
have broken out of their trading range but as you can see
the Fed Funds rate (light blue) is still relatively low. Also
note that the bull run of the 1990s took place with a Fed
Funds rate, and bond yields higher then current levels. The
rate is now slightly higher then it was in 1992.
Stage 5 is a period in which the Fed raises interest rates
in an attempt to slow business activity and curb inflation.
This, in turn, causes bond yields to increase.
Interest rates have been rising in the United States since
2004 and they recently began heading higher in Europe as well.
The US Federal Reserve raised interest rates for the 15th
time in a row at the end of March, 2006. Borrowing costs rose
a quarter of a percentage point to 4.75%. Rates have increased
from 1% over the past 19 months and are now at their highest
level since April 2001. The European Central Bank (ECB) also
raised interest rates by a quarter of a percentage point to
2.5% - the second change in rates in four months. In a historic
policy change, the Bank of Japan (BOJ) on 3/9/2006 scrapped
its five-year-old super-loose monetary policy and returned
to a more conventional regime, but said it would still keep
short-term interest rates around zero for some time. Japan
is the second biggest economy in the world, and their move
to a tightening policy will pressure our bond yields higher,
as seen last week.
The Semiconductor Cycle is usually a good proxy for the general
markets trend relative to the business cycle. When the Index
and its 50-day moving average cross the 200-day moving average,
a change in trend is usually confirmed.
Image : http://www.cetcapital.com/blog/images/Wilsh7yearApril06.jpg
The interest-sensitive Dow Utility Average tends to lead trend
changes in the broader averages. It has recently breached
its 200-day moving average for the first time since April,
2004.
During Stage 5, stocks top out and begin the early phase of
their bear market in anticipation of declining earnings. The
bearish influence of falling bond prices (higher yields) pulls
interest sensitive stocks downward. Eventually, the rest of
the stock market will also begin to weaken. This downturn
in the stock averages will often be accompanied with an upturn
in certain tangible asset stock groups, such as energy and
gold mining shares. Energy stocks usually lead the stock market
near the end of an economic expansion, which is usually associated
with rising oil prices. A spike in oil has preceded virtually
every recession over the past 30 years. The below charts illustrate
the uptrend in both stock and commodities.
The Fed target interest rate is highly correlated with
the CRB, and commodity prices have a greater than 90% correlation
with three important inflation measures (PPI, CPI, GNP deflator).
Commodities during Stage 5 continue to enjoy increased valuation,
as there is some considerable time lag between changes in
interest rates and its affects on business activity. Rising
interest rates also pull the dollar higher.
I am not a big fan of making market predictions. CET Capitals
beliefs are focused around price trends and momentum strength.
As of lately the markets have been moving up on strong volume
and are moving in a contrary direction to what the business
cycle is suggesting should happen. Based on where we are in
the business cycle I would not recommend using leverage currently.
Damian Campbell is President and head money manager
of CET Capital, a Registered Investment Advisory firm. He
oversees the testing and execution of all CET Capital investment
programs. Please visit us on the web at http://www.cetcapital.com
or call toll free 888-884-6468.
