20081124 Bus Cycle and Sector Rotation, Pt 1

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.

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.

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.