To maximize your performance, you must understand how the business cycle affects the economy and your investments. Economic activity alternates between periods of expansion and contraction, a process known as the business cycle. Unfortunately, the business cycle does not follow a fixed rhythm. The booms and busts vary in length and severity, and government actions can drastically quicken or slow the cycle’s phases.
The business cycle affects investors because stock prices and economic activity are linked. At long time horizons, U.S. stocks move upward as the economy does. But in the intermediate term, stocks are a leading indicator of how the economy will perform in the future; they often start declining or rising months before the economy does, though they occasionally generate false signals.
We can see the fluctuations in economic activity by looking at coincident economic indicators - data that tend to move in sync with the economy. A popular coincident indicator is the gross domestic product, or GDP, which measures economic output by calculating the value of the goods and services produced by the U.S. economy in a given time period. Unfortunately, GDP data is only available quarterly, comes out one quarter late, and is revised multiple times.
Luckily, we can track economic productivity with monthly data from the the Federal Reserve's Industrial Production Index. This index measures the real output of the manufacturing, mining, and electric and gas utilities industries from 1919 to the present (2018) with excellent accuracy. For a more robust picture, we can also use the monthly Coincident Economic Activity Index. This data considers a variety of economic statistics, including jobs growth, unemployment rate, wages, and average hours worked in manufacturing by production workers. Its data covers from 1979 to present (2018).
The chart below plots all three indicators to show you how they fluctuate over time; I scaled some of them for comparison. Whichever indicator you use, it’s clear that economic activity alternates between rising periods followed by shorter declining periods during recessions. Real GDP is on top in blue, the Industrial Production Index is below it in red, and the coincident index is on the bottom in black. The grey areas mark recessions. The National Bureau of Economic Research (NBER) defines those recession periods, but they do this considerably after the recessions already happened.
Academics and economists constantly bicker about what causes this cycle, proposing complex and contradictory theories that they are constantly revising. Instead of getting bogged down in the debate, let’s learn what the investing legends thought about the business cycle. The investors with the best success at identifying stock market turning points share some fundamental beliefs about the cycle’s causes and steps.
These investors believed that business cycles often follow a similar sequence of economic and financial events. This sequence of events repeats itself because the government uses the same methods time and time again to try to keep the economy running smoothly. Those methods have predictable consequences thanks to some basic, unchanging economic truths.
Lawmakers and the Federal reserve act as the economy’s mechanics and try to maintain its health. Their main goal is avoiding recessions and periods of excessive expansion. Here’s why.
During recessions, unemployment is high. This means:
Fewer citizens are paying income tax
Fewer people can afford to buy new things, which reduces the demand for goods, and thus prices decrease
Many citizens may struggle to support themselves and fall back on government programs, which increases social costs
The combination of reduced tax revenue and higher social costs puts a strain on the government’s budget
During overheated expansions, inflation is high. This means:
The cost of living increases because things are more expensive
Companies have to raise wages to meet workers’ high living costs
Higher costs reduce companies’ profit margins and ability to increase production
Consumer demand is still high, and it outweighs production and makes prices rise even more
The mechanics tinker with the economy to try avoiding these situations. Most of their tweaks come from the Federal Reserve, the U.S. Central Bank. It alters credit affordability to accelerate or decelerate economic activity. When it wants to accelerate the economy and/or end a recession, the Fed enacts easy monetary policies, which make credit more available and affordable for business and individuals. Cheap credit means businesses can more easily borrow money to expand their operations and produce more goods and services, and it means individuals can more easily borrow money to buy things, so demand for goods and services increases. Easy monetary policies are also called loose or dovish. When the Fed wants to decelerate economic activity, it enacts tight, or hawkish, monetary policies, which make credit less available and affordable for businesses and individuals.
Business Cycle's Steps
Let’s look at the cycle’s typical steps, starting during a recession. Here’s what usually happens:
To combat the recession, the Fed enacts easy monetary policies to make credit more affordable.
Stocks bottom out and start rising as investors anticipate economic recovery driven by the credit expansion.
The combination of low prices and affordable credit makes buying goods more attractive.
Consumer demand for goods increases, making prices rise.
Businesses see the high prices as a profit opportunity and want to start expanding again to take advantage. Employment increases, tax revenues increase, and corporate profits increase.
Increased consumer demand for goods increases their demand for money to finance those goods. Since credit is more in demand, it becomes more expensive; interest rates rise.
The rising prices (inflation) also make interest rates rise. Why? Because lenders want to make money. If inflation is 2% a year, lenders must charge more than 2% interest to make any money after taking inflation into account.
Interest rates don’t rise enough to significantly lower credit use and control the economic growth. During this time, the stock market, interest rates, inflation, and economic activity all rise in tandem. Despite the rising interest rates, stocks rise as investors anticipate continued earnings growth.
After a while the economic growth makes inflation reach excessive levels. Next, here’s what usually happens:
To combat inflation, the Fed enacts tight monetary policies to make credit less affordable.
Stocks peak and start falling as investors anticipate an economic downturn due to the credit contraction.
The combination of high prices and expensive credit make buying goods less attractive. Consumers don’t use as much credit or buy as many goods, so demand for both falls.
Expensive credit makes it harder for businesses to expand, so production of goods falls.
Reduced consumer demand for goods makes prices fall, which is what the Fed wanted. It also reduces companies’ profitability.
Reduced consumer demand for credit makes credit more affordable; interest rates fall.
The declining inflation also makes interest rates fall. During this time, the stock market also continues to fall as investors continue to doubt companies’ earnings potential.
After a while, demand for goods gets so low that businesses have to lay off workers. Unemployment increases, and eventually a recession sets in. The cycle restarts. Of course, reality can be far messier than this cycle suggests, which is why most investors should focus on identifying turning points.
Now we're ready to learn the best indicators to identify those turning points.
Spotting Turning Points
Monetary Tightening
When investors believe interest rates are excessively high, they often sell stocks, realizing that pricier loans may hurt businesses’ expansion efforts and future profitability. But we also know that, in the later portion of an economic expansion, stocks and interest often rates rise together. So how do we know when rising rates actually start to threaten the bull market? If the Fed funds rate (link) or the discount rate (link) is 5% or more, expensive credit be a real threat to the stock market, but only if there are other warning signs. Since 1929, seven out of ten stock market peaks had a fed funds or discount rate of 5% or higher. But on several occasions, stocks have done just fine despite one of those rates exceeding 5%. One reason this happens is because investors react the most to unexpected or inappropriate rate changes from the Fed. If most investors already expected rates to exceed 5%, they may not react strongly when that actually occurs. Also, the more that investors agree with Fed actions, the less strongly the stock market responds to those actions. Unexpected rate hikes, on the other hand, incur strong reactions from the stock market. Empirical evidence shows that unexpected rate hikes increase the odds of stocks switching from a bull market to a bear market. And if stocks are currently in a bear market, unexpected rate hikes increase the odds of that bear market continuing. Though these contractionary monetary shocks depress stock prices in both bull and bear markets, the effect is more severe in bear markets. Also, unexpected discount rate hikes tend to have a greater impact on stock prices then unexpected fed funds rate hikes. So if you see the Fed funds rate or the discount rate surpassing 5%, look for other signals of a turning point, especially price action, which you'll learn about soon. If you find a confirming signal, stocks are very likely to turn. This signal alone should make you cynical about the bull market, but is not enough to justify betting against it.
Market Breadth
Many popular stock indexes have a big shortfall: they don’t always accurately portray the overall movement of their component stocks. A 1% stock price change for a large company affects the index’s value more than the same price change for a smaller company. If several of the large companies in the index see their stock prices rise, the index can increase even if the majority of stocks didn’t. This flaw affects capitalization-weighted indexes, like the S&P 500, Nasdaq, Dow, FTSE, DAX, and many more. We can account for this flaw by looking at an index’s market breadth, which analyzes the portion of its stocks that are actually driving its movement.
Capitalization-weighted indexes calculate their values by adding up the market capitalizations of all of their component stocks and making some adjustments. The bigger a company’s market cap is, the more it contributes to the index’s overall value. This means stock price fluctuations for larger companies will move the index more than the same fluctuations for smaller companies will. Currently (11/2018), the 25 companies with the highest market caps in the S&P 500 account for 34.32% of its value, while making up only 5% (25/500) of its total number of stocks. When the index moves higher but its breadth decreases, this means a smaller number of stocks are responsible for the index’s uptrend. It also means many smaller companies’ stocks are falling despite a handful of larger companies’ stocks doing well. Investors call this a bearish divergence. If it persists, the uptrend may be weakening and likely to reverse. Similarly, a bullish divergence occurs when the index falls but its breadth increases. If it persists, the downtrend may be weakening and likely to reverse. The advance-decline (AD) line is one of the most popular market breadth indicators, but it has some drawbacks. It helps reveal the market breadth of all stocks traded on a particular stock exchange, like the NYSE. Everyday, it takes the number of an exchange’s advancing stocks and subtracts the number of falling stocks, producing the daily net advances. It then adds today’s net advances to all previous days’. Thus, the AD line plots how an exchange’s number of daily net advances changes over time. It rises on days when the number of advancing stocks surpasses the number of falling stocks and drops if the opposite is true. Note that a stock is considered advancing if it is making a 52-week high, and declining otherwise. Sadly, the AD doesn’t actually tell us the portion of an exchange’s stocks that are advancing. In fact, the AD line can increase even if the portion of the exchange’s advancing stock’s remains the same. If an exchange lists 100 stocks and 90% of them increase, its number of net advances is 80. But if the exchange actually lists 120 stocks and 90% of them increase, its number of net advances is 96. Currently (11/2018), exchanges have been increasing the number of companies they list, which gives the AD line an upwards bias. To actually track the portion of an exchange’s stocks that are advancing, we must divide the exchange’s net advances by its current number of listed companies. This is a hassle, because we have to constantly update the number of listed companies, but it’s the only way to track the percentage of an exchange’s listed companies that are advancing. But we can also track market breadth by comparing the performance of a large cap index with a small cap one. This doesn’t directly tell us how the portion of advancing stocks is changing, but it does tell us how smaller companies’ stocks are performing compared to larger companies’. Market breadth decreases when the small cap index falls while the large cap one keeps rising. Unfortunately, these indexes are still capitalization-weighted and place a greater weight on large companies. But each looks at a different group of stocks, and the large cap index has a much higher average market cap than the small cap index, so comparing these indexes provides a pretty clear picture of how small caps are performing relative to large caps. Whether they realize it or not, investors who use market breadth to predict markets are betting that smaller companies’ stock prices often fall or rise before larger companies’ do. Supposedly, smaller companies are more sensitive to economic conditions than larger ones, so their profitability and stock prices may start dropping before large companies’ profitability and stock prices. Confirming these beliefs requires looking at history. Soon before the market peaks of 2000 and 2007, small cap indexes stopped making new highs while large cap indexes continued to do so, shown below. But before buying this theory, we must also see how often small caps slumped without large caps following suit. I plan to do just that in one of my next books. Until then, take comfort that Stanley Druckenmiller, Victor Sperandeo, and many other high-performing fund managers analyzed market breadth to accurately call and profit from market tops.
Corporate Profits
Corporate profits are the most powerful indicator of the current business environment. Because they measure businesses’ real-world performance, corporate profits show you the overall impact of all the factors that affect profitability. They give you the bottom line, and that’s especially helpful when economic data releases present mixed signals. Fortunately for us, profits often peak and bottom out before the stock market and the economy do. In fact, from 1959 to present (2018), after-tax corporate profits bottomed out before 71% of stock market bottoms. 83% of all profits bottoms were accurate signals of a stock market bottom, while 17% were false positives. Also, profits peaked before 86% of stock market peaks. 60% of all profits peaks were accurate signals of stock market peaks, while 40% were false positives. This indicator, in combination with another confirming signal, is a powerful sign that stock prices have deviated excessively from businesses’ future prospects, and that the stock market trend is likely to change. Investors make their buy and sell decisions based on future expectations about companies’ profitability. But eventually, excessive optimism and fear cloud investors’ expectations about the future. Investors tend to be over-optimistic about stocks that rose substantially after they purchased them. They start to believe that the company’s success is the new status quo and is bound to continue; “this time is different.” Even the falling earnings can’t shake investors from their euphoria. They view slumps as temporary setbacks, and continue buying the stock even as the company’s profitability stops increasing, continuing to believe in the stock’s growth story. This is why bubbles form. Similarly, investors are often overly pessimistic about stocks that dropped substantially after they bought them. They start to believe those companies have no hope of rebounding any time soon. Even when earnings bottom out and start increasing, investors will typically feel that the increased profitability can’t last. They continue selling or avoiding those stocks even when earnings are bottoming out and increasing. The chart below shows the excessive optimism and pessimism before and after the 2000 tech bubble crash. How do we determine when profits peak and when they bottom? To identify a profit peak, find where the quarterly profit data has three consecutive points without making a new high, and then add a quarter. That extra quarter accounts for the data lag; quarterly profit releases usually come one quarter late, so we can’t see the peak until one quarter after it actually occurs. Similarly, to identify a profit bottom, find where the quarterly profit data has three consecutive points without making a new low, and then add a quarter.
Valuation
Investors’ excessive optimism or fear often clouds their expectations about the future, causing stock prices to deviate excessively from businesses’ actual growth prospects. As they fluctuate, stock prices can be wildly cheap, expensive, or somewhere in between. History shows that whenever stocks were grossly mispriced, they eventually corrected to more reasonable levels. The market is more likely to turn at these points of gross mispricings. But stocks can stay grossly mispriced for considerable time, and determining the thresholds for excessive cheapness and expensiveness is subjective.
If we set the thresholds to really extreme values, we’ll rarely detect that stocks are mispriced and place trades that profit from it. But if we set the thresholds too loosely, we’ll place our bets too early or get faked out. If we bet too early and stocks stay mispriced, our capital is tied up in a stagnant trade. We can determine the best valuation threshold levels by looking at history and noting the levels that occured at previous market turning points. To decide between potential threshold levels, we score each by multiplying the percent of market turning points it would’ve warned us about by the percent of its signals that were valid rather than a false positive.
Once we determine which of that metric's thresholds has the highest score and what that score is, we can compare it with the scores of the best thresholds for other valuation metrics. The most popular valuation are the P/E, Schiller’s P/E, P/S, P/B, and dividend yields. Famed fund manager Stanley Druckenmiller focused on the last two. He identified that the market was seriously overvalued before the 1987 stock market crash because its P/B was at an all time high and its dividend yield was a lowly 2.6%. If you use the P/E, note that history shows overvalued P/E levels are more predictive of market downturns if the ratio is high because earnings are falling. This is consistent with the fact that earnings often peak before the market does.
But isn’t the market's price always right? Isn’t a stock just worth what someone will currently pay for it? Not always. Several situations undeniably show that the market misprices companies. For instance, a company’s stock sometimes gets so cheap that the company’s market cap is below its liquidation value, which is the lowest, rock-bottom value of a business: the amount of money a business has after it shuts down, sells its assets, and pays off its liabilities. A business must at least be worth all the stuff it owns. So whenever a company’s market cap is below its liquidation value, the market has misvalued that company and succumbed to irrationally extreme pessimism.
Take another example. During the bear market in the first quarter of 2018, Amazon’s quarterly earnings were 42% higher than the same quarter one year ago, but its stock price fell 23%, caught up in the waves of frantic selling that were affecting the entire market. On the expensive side, during the Dot Com Bubble in 2000, the tech-heavy Nasdaq index increased 400% in just five years. Even back in the late 1630’s in Holland, Tulip Mania drove prices for tulip bulbs so high that you could trade one bulb for the price of a sizeable estate; once prices corrected, the tulip was as valuable as an onion. Clearly, the market value of stocks and other assets can defy rationality and be grossly inaccurate.
Don’t base your timing decisions on valuation levels. Druckenmiller has stressed that valuation levels only give you an idea of how far the market will probably move when it finally corrects its errors and returns to sanity; it doesn’t tell you when that will actually happen. For that, he recommends learning technical analysis, or price chart reading, which I discuss on the price action section of this page.
Earnings Calls
Market trends are likely to reverse when they no longer reflect real-world business conditions. One great way to assess those conditions is to listen to businesses themselves. On quarterly conference calls, business leaders analyze the recent quarter and discuss their company’s future prospects. If the market is uptrending but many business leaders say they worry about the current economic environment, an economic slowdown may be near, and the market’s uptrend may be nearing its end. Similarly, if the market is downtrending but leaders say they are seeing a real uptake in business, an economic recovery may be near, and the market’s downtrend may be nearing its end.
Keep in mind that business leaders tend to paint an overly rosy picture. So if they come out saying they are concerned about business conditions, take special note. In interviews, accomplished hedge fund managers Joe Vidich and Kevin Daly shared that they used earnings calls to analyze business leader’s sentiment and predict market moves. This helped Vidich predict the 2011 correction and Daly predict the 2008 bull market. Combining this with analyzing U.S. corporate profits provides a holistic picture of how businesses are actually performing, and helps you spot when the stock market’s movements are ignoring reality.
Price Action
These successful market timers respect chart reading as a powerful tool for determining market sentiment and anticipating trend changes. Why are stock price charts so informative? Stock prices reflect investors’ overall consensus on what stocks are worth. These prices result from millions of investors who meet on an exchange and say the price they’re comfortable buying or selling the stock for. When prospective buyers and sellers agree on a price, a transaction goes through and the stock changes hands. Stock charts simply show how that transaction price evolves over time. If the chart shows the price is increasing, you know that buyers and sellers believe the stock is more valuable than it was before. We don’t use charts to find a magical pattern that will lead to riches. We use them to draw logical conclusions about how market sentiment is evolving over time. For instance, if a price has traded in a narrow, directionless range for several months and then increases sharply beyond that range, we know that market sentiment experienced a sharp change from neutral to positive. We can’t predict how long or intensely that sentiment change will persist, but we can look to history to analyze similar sentiment changes from the past and note any reliable tendencies. Analyzing charts is also called technical analysis, which is a widely misunderstood skill. Novice investors forget that market sentiment often reaches excessive levels of optimism or pessimism, so we shouldn’t always place bets assuming the market is always right. In fact, the best technical tools help you determine when market sentiment defies reality and is starting to correct itself. Some investors dismiss technical analysis as a pseudoscience like astrology. But William O’Neil, who predicted the 2000 and 2008 bear markets, stressed that investors who can decode price movements have a big advantage over those who dismiss chart reading as hocus-pocus. As long as we remember that prices tell us about current and past market sentiment, and nothing more, we can draw valuable conclusions from reading charts.
Distribution Days
O’Neil’s main technique for detecting market tops is counting distribution days. A distribution day occurs when a stock market index loses .2% or more of its value on a given day, with higher volume than the previous day. It suggests that institutional investors are selling their positions, realizing the bull market is on its last legs. O’Neil tracks distribution days on both the S&P 500 and the Nasdaq indexes. When either one of these index sees 5-7 distribution days occur within five weeks, the general market has a strong chance of topping out. The images below show the distribution days that occurred before the 1987 crash, as well as the 2000 and 2008 market tops.
Down days with record volume may signal an imminent and severe price drop. A down day with record volume occurred just a couple days before both the 1929 and 1987 stock crashes.
Blow-off Tops
Blow-off tops occur when a stock market index increases exponentially. This acceleration results from speculative frenzy; investors are so euphoric about the bull market, they pile their money into stocks at faster and faster rates. The photo below shows the blow-off top that formed before the 1987 crash.
Before the crash day, Jones noticed this blow-off formation, and looked at similar formations in the past. His historical study showed that the stock market often falls sharply whenever an exponential price increase breaks down. He also found that the recent price action was closely correlated with the price action right before the 1929 stock market peak. These findings convinced him that the crash was imminent; he placed bets accordingly, and opened the biggest bond position of his career. Jones shared his findings with Druckenmiller, who realized in horror that he needed to reverse several large positions to prepare. Clearly, studying price behavior can drastically improve your odds of anticipating and preparing for major market moves.
Key Supports
During healthy bull markets, the stock market index stays above certain key price levels, known as supports. The market usually stay above these levels, sometimes touching them and bouncing off. But as market sentiment starts to sour, the market eventually falls below these levels and stays below them, indicating a dramatic, pessimistic shift in sentiment.
One key support level is the average price over the past 200 days. Since this changes every day, investors call it the 200-day moving average. It provides a smoother representation of the market’s longer-term trend. During bull markets, the 200-day MA usually increases over time and the market usually stays above it, sometimes touching it and bouncing off. But as the uptrend weakens and a bear market is developing, price often breaks below the 200-day MA and stays there. This indicates that current market sentiment is significantly different from its longer-term trend. The image below illustrates this during 2007, soon before the 2008 bear market. The blue line is the 200-day MA, which is identical to the 40-week MA on a weekly chart (each week has five trading days).
Other key supports include the 3-month low, round numbers (1400, 1450, etc.), and historical support or resistance lines.
During bear markets, the 200-day MA usually decreases over time and the market usually stays below it, sometimes touching it and bouncing off. As the downtrend weakens and a bull market is developing, price often breaks above the 200-day MA and stays there. This indicates that current market sentiment is significantly different from its longer-term trend. The image below illustrates this during 2009, right before the start of the 2009 bull market.
This tool is far from perfect. When markets are directionless, price often oscillates above and below the 200-day MA without beginning a substantial trend. Even during major uptrends, price can break below it and then snap back through it and continue rising. Despite these flaws, these investing legends still look at the 200-day MA to see when market sentiment has shifted dramatically from the long-term trend. This signal has an impressive track record; from 1950 to present (2018), you could earn a higher pre-tax, risk-adjusted return than the general market if you buy when the S&P 500 breaks 1% above the 200-day MA and sell when it breaks 1% below it. This result illustrates the predictive power (or statistical significance) of the 200-day MA, but it doesn’t prove that the 200-day MA strategy will beat the market overall.
You can also see a dramatic shift in market sentiment when the market falls below the below the lowest price in the past three months. Though this occurs after the true market peak, it still sometimes anticipates crashes. In fact, it occurred before the crashes of 1929 and 1987.
Lastly, you can spot a dramatic shift in market sentiment when the market breaks below or above a previously respected price level. These may occur at round numbers, like 1400 or 1450. The longer the market has respected that level in the past, the more significant a beak from that level is. The image below shows stocks breaking above a key resistance in 2009, developing into a bull market.
In the “Chart Reading” page, you’ll learn more about drawing resistance lines and why they provide insight.
Inverted Yield Curve
One of the most reliable recession indicators is the yield curve, which compares bonds’ short-term and long-term interest rates. Most of the time, long-term rates are higher than shorter-term rates. This rewards lenders for taking a bigger risk by loaning their money for a longer period of time. But sometimes the yield curve becomes inverted, and short-term rates exceed long-term rates. This occurred before all nine U.S. recession since 1955, with only one false signal. Even then, the inversion predicted a significant slowdown. Yield curve inversions also reliably predict recessions for countries around the world. Historically, these signals come well before the stock market peaks, and well before the economy peaks.
The inverted yield curve itself may negatively affect the economy. Banks usually borrow money in the short term to lend it out for the long term. But if the yield curve inverts, they would lose money from that kind of lending activity, so they reduce or stop it. This further reduces the availability and affordability of credit, which hinders business growth and increases the odds of a recession.
The yield curve can be either normal, flat, or inverted. The images below show you examples for U.S. Treasury bonds. These examples are from the bull market that started in October 2002 and peaked in October 2007. The ticks on the x-axis are different maturities of Treasury bonds, from one month to 30 years. Each tick has a corresponding interest rate, or yield. You can check this curve everyday from this page on the Department of Treasury’s website.
You can watch for a yield curve inversion another way. Just plot the difference between the yields of two bonds with different maturities. This is known as the yield spread, which you calculate by subtracting the shorter-term yield from the longer-term yield. Be sure that the bonds you compare have the same credit rating. Investors often track the spread between the 10-year and the 1-year Treasuries, shown in the photo below. You can track that spread using data from the Federal Reserve Bank of St. Louis by visiting here. The 10-year and the 2-year is another popular spread. Regardless, when the spread dips below the x-axis, that means the shorter-term interest rate exceeds the longer-term interest rate; the yield curve is inverted. You can see the spread dip below the x-axis before each recession, marked in grey.
Keep in mind that these inversions occur well before the economic expansion ends. The inversions often lead recessions by six months to two years, while the stock market leads recessions by an average of 5.7 months. The stock market often uptrends even after the yield curve inverts. So don’t bet against stocks rising just because the yield curve inverts. Just make sure that after an inversion, you take other warnings of a future market decline much more seriously. Remember, the inversion signals that a recession is fairly likely to happen in the next six months to two years. And most of the time, stocks will eventually decline and enter a bear market in anticipation of recessions.
Don’t be fooled by the financial media’s obsession with the flatness of the yield curve. Whether the yield curve is slightly flatter today than yesterday is meaningless for stocks. The yield curve can stay flat for extended periods of time, get close to inverting, but never actually invert for several years. All the while, stocks can continue showing impressive growth, like in the example below from the ‘90s. Don’t get bogged down by the noise. Just check periodically to see if it actually inverts. If it does, take notice; it’s a sign that the current economic expansion will likely end in the next six months to two years.
Because the Fed’s methods to control rates constantly evolve, you may periodically hear investors claim that yield curve inversions don’t matter anymore. Currently (2018), pundits suggest that interests rates are so low in general that a yield curve inversion is not significant. The Federal Reserve Bank of San Francisco disproved that claim, showing that the yield curve is powerful regardless of how high or low interest rates are in general. For investors, the yield curve’s predictive power has been pretty constant throughout the past 60 years, and most explanations arguing against the yield curve don’t hold water.
Now let's learn what the inversion really means.
The yield curve inverts when long-term bond investors strongly expect a future economic slowdown that would lower inflation and interest rates. If bond investors’ fear of an economic slowdown is strong enough, investors’ increased demand for long-term bonds will push their prices high enough, and yields low enough, to invert the yield curve. This signals that the bond market strongly anticipates an economic slowdown. Also, Fed tightening can increase the chance of inversion, since the Fed's tightening makes short-term rates increase.
How do we know this? It’s all about how bonds trade and the risks that bond investors anticipate in their trading decisions.
When you buy a bond, you are buying a future stream of cash flow and a future payment. For instance, a bond might give you $100 per year for ten years and then $1000 at the end. If you buy this bond directly from the borrower when they first offer it, you will pay $1000 for it. But if you wait a bit until other traders already own those bonds, you have to buy from one of them.
Like stocks, these bonds trade like items at an auction, and if more investors want to buy them than sell them, investors will bid up their price to something higher, like $1050. Now, you are paying a higher price for the same future stream of cash flow and future payment. You’re paying $1050 to get $100 per year for ten years and $1000 at the end. When you pay $1050 for that bond instead of $1000, you get a worse return on your investment, or yield. This is why bonds’ yields go down when their prices go up, and vice-versa.
Two main risks affect a long-term bond’s value: inflation and interest rates. As we learned from the business cycle, inflation and interest rates will increase during economic expansions and decrease during economic slowdowns. Bond investors buy or sell in anticipation of these risks, so bond prices and yields tend to move before these risks actually occur.
Bond investors also face the risk that the borrower defaults (can’t pay back investors) or gets its credit rating downgraded, but this risk is low if they buy government bonds. Thus, inflation and interest rate risks are the main drivers of trading activity for long-term government bonds.
Why are inflation and interest rates so influential? Remember that bonds give you a future stream of cash flow and a future payment. If inflation rises in the future, all of those future payments have less purchasing power, so the bond market will think the bond is less valuable and bid down its price. Long-term bonds face the most inflation risk because they have the longest time to maturity, giving inflation the most time to do damage. Also, as we learned from the business cycle, rising inflation will raise the interest rates that other lenders must charge to make money. When other loans’ interest rates increase, bonds appear less attractive, making investors sell bonds and move their money into other lending opportunities.
So rising inflation and interest rates make long-term bonds less valuable, which causes bond investors to decrease the price they're willing to pay for them. Falling inflation and interest rates make long-term bonds more valuable, which causes bond investors to increase the price they're willing to pay for them. Logically, long-term bond investors buy when they expect inflation and interest rates to drop sometime in the future, and sell when they expect the opposite. This is why bond prices and yields tend to lead inflation and interest rates.
Long-term bond investors are more concerned about these factors since they’re exposed to them for a longer period of time. This is why long-term bond prices and yields fluctuate more widely than short-term bond prices and yields; investors’ expectations of long-term risks can vary significantly, so their desire to buy or sell long-term bonds will vary significantly. In contrast, investors expectations’ of short-term risks vary less significantly, so short-term bond prices (and thus yields) are pretty close to the Fed’s short term rates. This is why the 1-year Treasury yield so closely follows short-term rates set by the Fed.
Now you know the causes and significance of an inverted yield curve. If bond investors expect an economic slowdown that will decrease inflation and interest rates, they buy long-term bonds, which become more valuable as inflation and interest rates fall. This buying drives up long-term bond prices, which makes their yield fall. If bond investors’ fear of an economic slowdown is strong enough, investors’ increased buying of long-term bonds will push their prices high enough, and yields low enough, to invert the yield curve. This signals that the bond market strongly anticipates an economic slowdown. Also, Fed tightening can increase the chance of inversion, since the Fed's tightening makes short-term rates increase.
ISM & LEI
These two economic indicators shed light on where we are in the business cycle and where business conditions are likely headed. The ISM Manufacturing Index measures the manufacturing industry’s health, which often deteriorates before the economy and stock market do. This index tracks a group of statistics, including production, new orders and supplier deliveries, employment, and inventory levels. The data comes from surveys of purchasing managers at over 300 manufacturing companies. These employees experience the daily fluctuations in demand and have a good sense of the overall economic health.
Raoul Pal, who produces economic research for the world’s top hedge funds, believes that the ISM is the best indicator of the global business cycle’s trajectory. He notes that when it crosses below 47, the chance a recession will develop is 80% based on data since 1896. And whenever it falls below 46, an economic recession has always followed. The ISM also has a remarkably close correlation with the S&P 500 YoY price, as well as its YoY earnings. This suggests the business cycle ultimately drives stocks’ earnings, which drive their prices.
The ISM also strongly correlates with YoY lumber and oil prices. Whenever lumber or oil’s price trend significantly diverges from the ISM’s trend, that price trend is likely to reverse in the near term. But the ISM sometimes shows a weaker relationship with commodity prices. Some commodities can periodically undergo massive phases of excess speculation or demand increases, regardless of how the ISM is behaving. Copper’s two massive price spikes in the 2000s resulted from China’s enormous increase in infrastructure spending, causing copper to move independently from the ISM during that time.
Credit spreads also follow the ISM. The difference in interest rates on BAA and AAA bonds tends to widen following a drop in the ISM. This suggests that as the business cycle weakens, lenders become more nervous. Inflation also closely follows the ISM. Since inflation is a main driver of bond prices, bonds had strongly correlated with the ISM. That relationship died due to the U.S. government’s enormous quantitative easing campaigns that artificially affected bond prices.
The Leading Economic Index (LEI) tracks a robust group of statistics that have the best records of turning before the economy does. Every month, the Conference Board releases the LEI’s value, considering factors like consumer sentiment, manufacturing and supplies, demand for goods, stock prices, and the real estate market. Whenever its value is high and on the rise, the economy has continued to grow. This indicator efficiently conveys the U.S. economy’s future growth prospects, and lets you identify when the market’s trend is no longer reasonable compared to the business reality on the ground.
Sentiment & News
An asset’s price reflects what traders are willing to buy and sell it for at a given time. Its price rises when traders increase their opinion of that asset’s value. Since sentiment drives that opinion, we can use it to inform our predictions about where prices are headed. Most of the top-performing investors evaluate sentiment by analyzing how prices react to fundamental news like economic data releases, new monetary or fiscal policies, and scandals.
Investing legend George Soros emphasized that sentiment and reality interact with each other to form feedback-loops; this reflexivity explains why trends that defy the facts can continue for substantial time periods. His book Alchemy of Finance explains that “when a situation has thinking participants, the sequence of events does not lead directly from one set of facts to the next; rather, it connects facts to perceptions and perceptions to facts in a shoelace pattern.” Soros profited from trends rooted in faulty market sentiment; he aimed to step in the trend and leave before the rest of the market realized that the trend isn’t justified by the facts. But he has also famously profited by betting against a faulty trend when it is visibly cracking and investors are waking up.
Most fund managers determine general market sentiment by comparing market indices react to news. Victor Sperandeo especially focused on the Dow Jones Industrial Average and the Dow Jones Transportation Average. Many of them also zoom into a particular sector, stock, or asset class and compare its price movements with its relevant news.
Traders can also detect sentiment by watching how prices react to popular headlines and opinions in the financial media. Hedge fund manager Scott Ramsay predicted one of bonds' bull markets by realizing that bond prices weren't falling despite most financial news outlets and commentators being down on bonds. This suggests that many investors were shorting bonds despite bond prices holding firm. If the market keeps pushing bond prices higher, those investors will have to cover their shorts, unleashing waves of buying that could make prices soar. Additionally, when trading magazines publish cover stories that rave or ridicule about a particular asset, its trend is very likely to reverse imminently.
Druckenmiller notes that determining sentiment by comparing price movements and news hasn’t worked well in recent times, as central banks increasingly use monetary policies that artificially move prices in directions that don’t reflect market sentiment.
You can also watch the options market to assess traders' moves and how they are betting. Options contracts let investors temporarily profit from the movement of more assets than they can actually afford. This leverage comes with a price, and options get more expensive the more that options buyers expect prices to move in the future. My options book goes more into details, but just know that investors most investors buy call option contracts when they expect price to rise, and put option contracts when they expect it to fall. When puts are drastically more expensive than calls, the market sentiment may have reached excessive pessimism and prices may soon bottom.
Fallen Leaders
During his prolific investing career, William O’Neil watched the stocks of the companies with the most impressive earnings and stock price growth. He found that when these leading stocks start turning down, a market correction is more likely. These businesses tend to be young and small, and they often take more risks than average in order to continue their rapid growth rate. These factors makes these companies highly sensitive to economic conditions, so their profitability and stock prices may start dropping before the rest of the market.
O’Neil especially took note if these leaders’ stocks slumped after attempting to break out from more volatile price structures, which tend to occur later in the bull market. But in 2017, this indicator worked poorly. Many leading companies failed to emerge from choppier price structures, yet the general market continued its steady rise. One reason this indicator can produce false signals is because the sectors accounting for the general market’s growth vary over time. When the most recent leading sector peaks out, the general market’s most recent leading stocks will peak out too. But the market can keep rising if another sector picks up the slack. However, looking at leading stocks’ behavior still helps you analyze the market’s strength.
Additionally, the leading stocks within a particular sector can inform you about that sector’s future trend. For instance, when the most profitable energy companies with the highest stock prices start falling substantially despite the sector index continuing to rise, that index may be near a reversal.
Credit Spreads
When financial institutions start doubting each other’s solvency, the financial sector is displaying severe pessimism about the country’s economic and financial health. This pessimism itself can lead to a shortage of credit availability, which hinders business growth. It also signals that the financial sector expects imminent market turmoil. We can spot when lenders are getting nervous by monitoring the spread between the rates on overnight loans and slightly longer-term loans. Michael Platt and Colm O’Shea both used this indicator to anticipate the 2008 financial crisis. When you loan money to someone overnight and they promise to repay the loan the next day, the risk that they’ll default and be unable to repay is minimal. But if you loan money for a longer time period, like 90-days, the borrower has considerably more time to go bankrupt, so the risk is higher. That’s one reason why lenders generally charge higher interest rates for longer-term loans; they want compensation for the increased risk of default. The bigger the difference, or spread, between the longer-term rate and the overnight rate, the more concerned lenders are that borrowers will default and be unable to repay them. The LIBOR-OIS spread compares the Overnight Indexed Swap (OIS) rate with the slightly longer-term London Interbank Offered Rate (LIBOR). The wider it is, the more compensation lenders want for lending money for time periods significantly longer than overnight. This spread spiked to unprecedented levels prior to the 2008 financial crisis and bear market. You can track it here.
Pitfalls
Using the Buffet Indicator The Buffet Indicator compares the market cap of a country’s stock market with its GDP, which measures revenue. Supposedly, if the ratio is too high, stock prices are valuing businesses far more than businesses are actually earning. That means stocks are overvalued, and investors should invest in other assets or bet on stocks returning to more reasonable levels in the near future. The flaw: GDP does not account for U.S. businesses’ revenue coming from overseas. From 2009-2013, the top 500 biggest companies received about 46% of their revenues from overseas. The Buffet Indicator values businesses based off of a flawed, lowballed measure of their revenues. The underlying concept does have merit; stock valuations shouldn’t drastically exceed the amount businesses actually earn. But investors should use the Price-to-Sales ratio instead. This compares stock prices to all company revenues, those from abroad. Fighting the Last War I try keeping my content cliche-free whenever possible, but these two are worth noting. 1. History doesn't repeat itself, but it often rhymes. 2. Generals often fight the last war. The exact causes of bear markets never repeat, but many of them share several symptoms. In 2000, tech stock prices reached comedically high levels while economic conditions deteriorated. When the bubble popped, the markets had to drop severely before reaching reasonable levels. In 2008, the financial industry used excessive leverage to massively invest in mortgages, but when housing prices plummeted, tons of homeowners couldn’t pay off their loans. Delinquencies skyrocketed, and the value of mortgages nosedived. Many major banks went bankrupt, which contributed to already worsening economic conditions, business profitability, and stock prices.
Trusting Economists’ Opinions Sadly, economists have a dismal ability to predict the future. According to research from the International Monetary Fund, economists failed to predict 148 of the past 150 recessions that occurred around the world from 1992 to 2014. They regularly fail to predict strong economic booms as well. Several theories may explain this. Economists’ models may fail to determine how unpredicted events, like terrorist attacks or drastic policy changes, change the economy’s trajectory. Also, if they argue an unpopular opinion and are wrong, their reputations suffer considerably, but if they argue a popular opinion and are wrong, their reputations stay unharmed. If their unpopular prediction is right, they receive only moderate benefits. Lastly, like most humans, economists dislike admitting that their initial predictions were wrong. So when new information changes the situation, economists only make slight adjustments to their initial beliefs so they can still feel like they were right. Overall, though they may be able to analyze the present, economists fail to predict the future; they often under-anticipate it and assume that the present trend will continue. So next time you read a headline about what Paul Krugman said about stocks, don’t take it too seriously.