What's the Best Asset Allocation When the Business Cycle Moves to Stage IV?
History shows that the business cycle, which has been with us since recorded economic history began, experiences a set series of chronological sequences. The calendar year progresses through seasons, one of which is literally ideally suited for making hay. The business cycle also has seasons or phases, where certain sectors of the economy fall in and out of favor. For investors, the key lies in the fact that the cyclical turning points of bonds, stocks and commodities are all part of the business cycle progression.
This is shown in Figure-1, where it is apparent that the cycle can be split into Six Stages.
- First bonds bottom as the Fed eases and credit demands weaken.
- Stocks, eventually sensing that the falling rates will result in another recovery anticipate the revival by typically bottoming at the point of maximum downside economic momentum. This justifies the counter-intuitive “buy when the news is blackest” mantra.
- Later commodities bottom (Stage III) as a sustainable demand by commercial users picks up.
- This price rise and associated pick up in the demand for credit later causes interest rates to move up. That means the start of Stage IV and a peak in bond prices.
- Eventually the rally in rates picks up steam, worrying equity market participants, who now fret about the next slowdown or more likely recession. That brings on Stage V.
- When a reduction in end demand pushes commodity prices lower Stage IV then takes over as all three asset classes are now in a declining mode.
The process begins all over again after this Stage VI liquidation phase has run its course. Figure-1 implies that each stage has an identical duration, but in reality that’s by no means the case as each phase varies in length from cycle to cycle. Sometimes specific stages are even skipped as the models advance more quickly. It’s not a perfect world out there but this approach offers a good working framework.
We identify the Six Stages with three models, one for each asset class. Their status tells us where we are in the Figure-1chronology. When all three arel bullish that tells us we are in Stage III and so forth. Their status also forms the basis of the Dow Jones Pring US Business Cycle Index (symbol DJPRING).
Chart 1 Pring Turner Commodity Barometer
The models skipped from Stage II in December to Stage IV at the end of January. That means that the current environment is negative for bonds but positive for the other two asset classes. The individual Stage IV’s in the last 50-years have returned a negative 8.3% for bonds, and plus 9.4% and 12.8% for stocks and commodities respectively. Chart 1 features one of our models, the Commodity Barometer. Its components comprise trend, momentum and inter-asset relationships and it goes bullish for industrial commodity prices when it moves above its 51% threshold. The CRB Spot Raw Industrials is used as a benchmark because of its economic sensitivity. Weather related distortions associated with agricultural commodities are therefore avoided.
Chart 2 Commodity Prices versus the Economy
Economic factors also support the transition to a bullish environment for commodities. In that respect Chart 2 compares the performance of long-term momentum for the CRB Spot Raw Industrials to that for a similar measure for the ECRI Weekly Leading Indicator. The arrows show that when the ECRI momentum crosses above its equilibrium level this is positive for commodity prices on a primary trend basis. The latest January data triggered the sixth such signal since 1970 . I also confirms that the 2011-2012 growth slowdown is over. Based on this historical relationship ECRI momentum is now forecasting higher industrial commodity prices.
Since Stage IV is an inflationary phase for the cycle it means significant shifts in client portfolios and the Pring Turner Business Cycle ETF (DBIZ). Stocks consistently gain in Stage IV but the mix favors a more inflation sensitive exposure and a general movement away from defensive and interest sensitive issues. Fixed income should be avoided as much as possible. To offer an example of performance, Stage IV monthly returns on an annualized basis since the mid-1950’s have averaged 22% for oil drillers,17% for domestic oils, 18% for miscellaneous metals and 14% for semiconductors. Commodities, of course do well with copper (25%) leading the list followed by crude oil (17%),platinum (15%) and gold (14%). These, of course are average returns and each cycle has different characteristics. Individual sectors may fail to live up to their reputation in a specific cycle, but the general principle of overweight inflation sensitive underweight defensive areas is unlikely to prove disappointing.
How long will this phase of the cycle last? There is no way of knowing. It’s duration will probably be determined by the speed of the commodity rally and equity investors assessment of how that will affect the interest rate environment, economy and profits. All we can say with any degree of certainty is that since the mid-1950’s the average Stage IV has lasted 6.5-months. That would take us to the July/August period when cyclic and seasonal analysis points to a peak in equities. In the meantime enjoy the ride!
Martin Pring is Chairman of Pring Turner capital and strategist for the Pring Turner Business Cycle ETF (DBIZ)
ATTENTION: This is not an investment recommendation or a solicitation to become a client of Pring Turner Capital Group ("Adviser"). Unless indicated, these views are the author's and may differ from those of Adviser or others in the firm. We do not represent this is accurate or complete and we may not update this. Past performance is not indicative of future returns. For additional information and important disclosures, contact me or www.PringTurner.com.
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