ROGER HIRST: So now let's look at a few cyclical trends and indicators. Whilst there are quite a lot of cyclical trends that we can talk about, I really want to focus on one in particular, and that's the business cycle. Trying to identify where we are on the business cycle is the holy grail for many investors.
Let's first start off with a stylized version of that cycle, and why it matters. And then we'll look at a few indicators which can help us work out where we are on that cycle, and how we might make money. So here's that simple depiction.
Economies generally go through periods of expansion, which then peak. Growth eventually rolls over into recession, which finally troughs. And then the expansion phase starts all over again. Well, at least that's the theory.
But why does this matter? Well, generally different assets and sectors all behave differently in each of these individual phases. For instance, in the early phase of the expansion process, cyclical equity sectors such as industrials or basic materials, may be outperforming due to their sensitivity to the economy.
But then, once growth peaks and moderates, stocks which have steady earnings growth often start to outperform. They're called growth stocks. But rather annoyingly, the "growth" in growth stocks does not refer to economic growth. Next up, when growth is rolling over and we might be heading into a recession, defensive stocks such as utilities would likely outperform relative to others. But we may even want to get out of risk assets altogether, because things often correlate to one on the downside, which means they all sell off together.
Now, that was a brief resume for equities, but other asset classes may also perform differently in each of the different phases. Similar to the industrial stock sector, industrial metals should also outperform during the early expansion phase. And if this is a global cycle, emerging market currencies may also outperform, especially if they are commodity exporters. Inflation should start to rise and bond prices fall as the expansion phase builds momentum. And when growth eventually stalls, historically, bonds have generally rallied, and yields fallen, especially as we head into a recession.
Now, we have to reiterate here that these are all very stylized versions of the business cycle, and the performance of assets. During the Eurozone crisis of 2011 to 2012 for instance, some bond yields moved significantly higher, even as growth slowed, because of worries that some governments would default on bond payments. And as I said earlier, each cycle is different, so you need to understand the principles behind the market drivers, and the asset classes, so that you can navigate whatever environment comes your way.
And that is absolutely key, because business cycles can be longer or shorter than expected. Growth can be stronger or weaker than expected. Just look at the different cycle lengths between recessions over the last 60 years. Since 1980, cycles became very extended. But during the inflationary 1970's and early 1980s, there were many recessions in quick succession. So the secular backdrop can help define the length and depth of the cyclical environment.
And what's more, policymakers are constantly tinkering with the tools in their toolbox, such as interest rates, their balance sheet, as well as regulation, in order to prolong a growth period, or due to recovery out of a recession. What they are usually trying to do is loosen or tighten financial conditions, which Julian Bridgen outlined earlier in the module. And that's why we use a whole array of indicators to try and filter out that noise. And that's what we'll look at now.
But first, we need to think of three types of indicators, or three ways that they operate. There's leading, which means effectively thinking of the future. There's coincident, which is what's happening right here, right now. And there's lagging, which is what's gone in the past. Now normally, we're looking for those leading indicators, but the other two can help us define where we are in the various cycles.
I also want to point out that in this module, we're really focusing on the US as the main economy that influences the rest of the world. So it's going to be their indicators that will be the main point of analysis. But other countries have very, very similar indicators as well.
You need to be mindful in understanding what drives other countries economies. For instance, the US is very consumer driven, but other countries may be driven by exports, or the supply of commodities and products that are then consumed by places like the US. So everything is interlinked.
So now, let's turn to some of those indicators. One of the all time favorite indicators of the business cycle, and we all spent a lot of time chatting about this in our discussion, is the US yield curve. But remember, this is still very much an art, and not a science. None of these indicators are perfect. But when we combine them, and try to build a picture of what's going on, we might get a clearer view.
The yield curve basically charts the differences in interest rates across different maturities of related bonds. It's most widely applied to the government bond market. To measure the difference in long-term rates, the banks lend money at, and short-term rates that banks borrow money at. So let's look at the difference between yields on the 10-year benchmark, and two-year benchmark in the US.
That one tends to be the most widely used curve. It reflects the bond markets growth expectations, and the expansionary and contractionary phases in the business cycle. And what everyone's really looking for here is when the curve starts to invert. And an inversion is where those two-year yields go above the 10-year, and therefore, you get what they call this inversion, because we're taking 10-year yield minus two-year yields. And the reason why people think they love this part of the curve is that the inversion takes place before a recession.
But the problem is that inversion can take place anywhere between nine and 34 months before a recession. So as a timing tool, the yield curve is not particularly strong in terms of timing those recessions. But what about how well it can time the performance of other assets, such as the equity market?
Well, when we look at the yield curve versus the S&P, we can see a little bit of a relationship over the last 30 years. In fact, the deepest point of an inversion since 1990 has often coincided with something close to the peak of the S&P. But the difficulty with this is you don't if you're at the deepest point of the inversion. So you don't actually if this should be the point to start selling equities. So once again, the yield curve versus the S&P is not necessarily a great timing tool.
And furthermore, during the 1970's era of inflation, the yield curve dynamic was different yet again. An inversion still took place before a recession. But then the inversion continued into the recession, rather than bottoming and rebounding. So signals from the yield curve in times of high inflation may be different from periods of low inflation.
Therefore, some people like to add in other elements such as business surveys like the Purchasing Managers' Index, or PMIs. In the US, the Institute of Supply Management is the governing body that produces the benchmark manufacturing and services PMIs. So what the ISM? What is a PMI?
Well, it's a monthly survey of business sentiment, which provides a great amount of information beyond its headline reading, and is often a pretty good lead on the relative strength of the economy. It's broken into subcomponents, such as new orders, inventories, and employment. And these are things that we will touch on in a moment.
Although manufacturing is a smaller part of the US economy than services, the reason why we love the ISM manufacturing PMI is that the manufacturing component is much more sensitive to changes in economic activity, and tends to be followed more closely as a result, because of that volatility. And the way we use this one is that generally, a level of 50 is seen as the threshold between expansion above 50, and contraction below 50 in the manufacturing sector, and by extrapolation, the broader economy.
Before a recession however, at least since the 1990 period, the ISM has tended to be close to 45 before a recession actually occurs. And the ISM has been under 50 on many occasions without a recession occurring. So whilst the ISM is a useful guide, there is also a lot of noise. And also, it may just be a coincident indicator with the equity market.
When we follow the year over year change of the S&P, it looks like it follows the momentum of the ISM report. When the ISM is falling, the year on year change in the S&P tends to be in a downward trend. And when the ISM is rising, so too is that year on year return on the S&P.
So the S&P has tended to mirror the changes in the ISM. And if they are coincident, then the use of the ISM as a market timing tool needs to be combined with yet other indicators in order to generate a picture of where we are in a market cycle. And furthermore, again, the relationship between the ISM and recession starts to break down when we go back to the 1960's and that period of inflation. Recessions during the inflationary period of the 1970's tended to start when the ISM was above 50, or even 60, rather than at 45 as we saw post-1990.
But there are other surveys that we can use that may be better connected to the real economy. Sentiment surveys for consumers and small businesses may be closer to the US economy than the ISM, which reflects sentiment for larger corporations. Here, we can see the combined NFIB Small Business Optimism survey, and the University of Michigan's Consumer Sentiment surveys. And these really are looking at the more general sort of population and economy of the US.
Consumers or consumption account for about 70% of the US economy. And mom and pop and small businesses account for a greater element of employment in the US than the companies that contribute to the ISM. So if we combine the two, we're really getting a little bit more of the sentiment of the average Joe within the US.
And what we can see here is that when these two are combined, there seems to be some relationship between the falls in the index, and when we get recessions. But that doesn't mean that the ISM is obsolete. And that's because of the subcomponents that we mentioned earlier.
With these, we can glean extra information from drilling down into the subcomponents, and the respondent's comments, which are contained within the report. For instance, we can look at things like new orders, employment, and prices, all subcomponents. Comparing the spread between new orders and inventories can also provide a slight lead on the headline index. If net new orders turns negative, then there isn't that excess demand to propel the economy. In fact, it often tells us that consumption has been pulled forward, if inventories have built up, and demand begins to wane.
Furthermore, we can see respondents' comments within the report. And these are reported by sector. You can even cross-reference these to the NAICS database, or NAICS database, which has a library of all the related industries and stocks that could potentially be affected by these comments, and may even have provided them originally, albeit anonymously.
As well as the yield curve and the ISM, are other cyclical indicators whose relevance has only been apparent in recent years, such as the expansion and contraction of central bank balance sheets. Although the relationship is hard to clearly quantify, it'd be very difficult to deny that there has been a relationship between central bank balance sheets and many asset prices. Policy clearly has an influence.
Now, cynics might suggest that policymakers are the cause of every recession and asset bubble to have ever occurred. And whilst that might be rather stretched, there is clear evidence of the effect that quantitative easing has had on equities since it was adopted after the Great Financial Crisis. Expansion in central bank balance sheets saw the US stock market grind higher over a decade. Whilst there was an attempt to taper asset purchases and shrink this in 2018, it wasn't long before the Fed capitulated as the S&P 500 became more volatile, and showed signs of topping.
So it cuts both ways. And there's no denying that policy drives asset prices by influencing the cyclical trends in the economy. Whether it's via interest rates, or monetary easing, policy makers pull the levers to add and remove liquidity, and determine the course of the cycle by affecting credit conditions. And we can also see the influence of QE on the performance of global bond markets. QE has run in cycles. And the expectations were that bond buying by the central banks would drive yields lower.
But bond buying periods were actually periods of high yields. And periods when there was no bond buying actually saw yields going lower. And that's probably because of the reaction function. Yields were falling in periods of a weaker outlook for the economy, forcing central banks to step in. And with that, that Pavlovian conditioning of safety came back in, and we saw yields rise as the economy stabilized. And just as they thought the economy had stabilized and stepped back, things rolled over again, which is probably why we have that anti-cyclical move between bond yields and QE.
So all these indicators are really trying to tell us about the relative health of consumers and corporates. And for the latter, credit spreads, which is the difference between interest rates on corporate debt versus interest rates on government bonds within the same time frame are one of the better indicators for economic health. If credit spreads are widening out, then corporates are having to pay more and more in order to borrow. If the cost of capital is rising, then the chances are that business is slowing. It's unlikely that we'll experience a recession if corporate funding costs are still extremely loose.
And you can see the credit cycle in the spreads between high yield and investment grade bonds. The spread will blow out as investors shun riskier assets, such as high yield or junk bonds, in favor of investment grade bonds. Rather like inversions in the yield curve, this often precedes a recession. But if the Fed moves to cut rates and stimulate the economy, then risk appetite should improve, and see speculators buying up riskier high yielding securities given the looser policy environment.
And there are other much shorter and often relatively random cycles that we can use, such as inflation. All peaks in CPI have occurred during recessions except 2000, when it occurred just beforehand, and then the exogenous shock of COVID in 2020. But surges in inflation can impact corporate margins, and lead to a policy response of tighter conditions. Inflation cycles therefore, have an impact. But knowing when inflation has peaked at any one point in time is still extremely difficult.
So far, we've mainly been looking at those US indicators for the reasons we mentioned earlier. But many of those indicators will work in other regions where they have their own PMIs and their own inflationary cycles. But the US is still the main driver of global economic activity.
The reason why we look at China however, was very clear in 2016. There had been a global profits recession. There had been a few wobbles in the US equity market. Volatility had picked up. Unbeknownst to most people watching at the time, China had stuffed its channels with credit once more. And if you look closely, you'd have seen that commodity stocks had started to outperform the broader market.
This was a new cyclical trend potentially within that secular pattern that had been building pretty much over the last 20 years. And the importance for China in the secular trend is that at some point, it's going to move from being the biggest demand for raw materials, or the biggest rate of change in demand for raw materials, to plateauing out and moving towards its own consumption model. And that's one of the great secular trends that people are constantly looking out for today.
So the point here is that whilst we focused on the US for the majority of our cyclical indicators, we can't forget that that is part of a global framework which involves many other players. China is perhaps the most important. But you can look at all these trends within regions and within countries.
You can look at surveys within Germany, and surveys in Japan. And they are just as valid as the ones that we can use from the US, and can help individuals within their own markets define their own investment framework from all of these global cyclical trends. Cyclical trends are clearly apparent in the various indicators we've seen, such as the yield curve and ISM.
But some of most interesting cyclical opportunities will be where they intersect with major secular trends. And as with any cycle, there are peaks and troughs, which can provide inflection points in the market regime. One such example that we all need to monitor over the next few years is whether that spike in inflation in 2022 were the first cyclical shot of a new secular regime in which inflation re-bases to a higher level, and the length of time between each recession is shortened if the business cycle becomes more volatile.
Well, once that spiker went off, this is something that we're going to have to monitor with the tools that we've mentioned above. But investors will inevitably get ahead of themselves in trying to anticipate these cyclical trends and be wrongly positioned from time to time. And that's where the tactical considerations come in.
And as we've seen with the chart and inflation, there is an argument that the business cycle is becoming more volatile, and possibly, shorter in length since the 2020 pandemic. The potential was playing out before our eyes in 2022. Now, most of the tactical trades are best viewed on short-term charts, which we'll look at in the next module. But let's have a quick look at what we mean by trading or investing on a tactical basis.
Basically, if the cycle shortens in length, or increases in volatility, we may need to pay more attention to tactical considerations. That was the case during the .com market bust. The cyclical trade was to be short for the bear market. But in a practical sense, it was extremely hard to be short, because of the numerous very sharp rallies in the market that would have stopped out and forced investors to close many of their short positions.
There were two rallies of around 20% in 2001 alone. And one of the principal reasons for trading on a tactical basis is when volatility is high. During this period of the .com bust, volatility on the NASDAQ 100, where most of those tech stocks were listed, averaged around 50% for 2001 and 2002. Now by way of example, people consider the S&P to be volatile if the VIX is in excess of 20.
Other tactical considerations are news flow and events. People often trade tactically around data releases or earnings reports. Major options expiries also provide opportunities for short-term tactical trades. The lows on the S&P in December 2018 and March 2020 came on the first trading day after a major options expiry. Not only that, but the lows in 2020 were around the time that many countries went into lockdown.
Look, the point being here is that the market had priced in the lock-downs before they started, a reminder that major events can be tactically priced in over a very short time period, and often, well in advance of the actual cycle starting to emerge. Sentiment is also another opportunity for tactical trading. Is an asset overbought or oversold? And has that occurred with a shift to extremely positive or negative sentiment? And that's where chart patterns and other indicators can play a very key role in that decision-making process.
So tactical considerations are often a key timing for an entry or an exit point, but they are usually less relevant for the longer term investors who are trying to play a multi-year cycle. It all goes back to what type of investor are you? And the answer to that will infer the type of trends most relevant to you.
So to recap, we have three key trends, secular, cyclical, and tactical. Secular trends that underpin any investing environment often involve a time frame that extends beyond our investing careers. Therefore, we should focus on the cyclical and the tactical opportunities. None of the tools we use to identify these trends are perfect, but you can adapt them for your own investing framework.
So to recap, the focus of this workshop has been to help you identify the different economic environments and the trends accompanying them. Whether you're a long-term investor looking to optimize entry points, or you're a short-term trader that needs some broader context, understanding the different market drivers should be beneficial to your process. And to help you with this, we looked at several different indicators across the secular, cyclical, and tactical levels, and showcased why monitoring them matters.
And it's worth spending some time thinking about the following, based on who you are as an investor, which indicators will you start with when building your investing framework? When you start by looking at the secular, the cyclical, or maybe even the tactical areas, and why would you do that? Within each of those categories, which specific indicators will you be looking at? And how often will you monitor them?
And once you've gotten a handle on the indicators that align with who you are as an investor, which of the other two types should you be building awareness of? And go play around with some of the economic data. There are some wonderful charts on the economic database of the St. Louis Fed. Thanks very much for watching.