What do you know about cycles? Are they predictable?

Kids, that's a great question and one that is often overlooked....

If there is one thing that is certain in the world, it is that cycles are inevitable. Not every cycle looks the same, not every cycle is as predictable as the last one. Human behaviour is the underlying cause for cycles, of that I have no doubt.....

The best historical evidence of cycles are the Empires. Greek, Roman, Ottoman, Persian, British to name just a few. They are littered with similar facts and waves of success and in all cases, decline. There were significantly different reasons why the Empires came about. The British Empire was one of Naval warfare and success. The Romans won on land and Sea (Europe/Meditteranean/Egypt), the Greeks on the Ocean (but locally), you get the point. Learning from these cycles is of the utmost importance to understand the potential pitfalls of the future.

The most recent cycle for the US had the hallmarks of 1907 with a very similar financial crisis. If you want to read a quick book about it click the link. Was it predictable? If you were looking in the right place it was. I looked at the yield curve, it helped me, not others (human behaviour at its' finest). Some people looked at the source of financial leverage and could see a serious issue. The annecdote that stands out, that I couldnt understand completely, was how everyone was renovating their kitchens for gigantic sums of money, surely that couldnt be right. As it turned out, it wasn't.


Yield curve chart

The chart above is a picture perfect cycle chart, peaks and troughs.....wonderful.

Consumer Confidence



As you can see from consumer confidence, the peaks and troughs are gigantic.They are not quite as priceless as the yield curve, but it does show human nature through good and bad times. This can also be seen in Wages below.

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There are also cycles within cycles. This is best seen with stock markets and stock market behaviour. Below are the conditions that I like to note.....

Phase I:
Early cycle sectors include: Transports, Semis, Finance, Retail (there are others). I class this part of a bull market as PHASE I
This phase has been well discussed and documented, it is the predictive phase without solid evidence that it will happen. The rising tide has a habit of raising all boats. Consumers become more confident, spending habits start to return and populations start to finally see some benefits of better economic news in jobs. The moves are violent, sometimes eye-watering. If the market is discounting future bad news, you know you are on the right side. SPX likely outpaces Russel 2000.

Phase II:
The next phase becomes quite tricky to predict and navigate. Phase II sees spending habits return to a cyclical pattern. Spend some money at christmas, pay off the credit card in January through March. You also see some bigger ticket items being bought at the expense of other discretionary purchases. For instance, if you need a new car, you will source the money from the same pot of money, but it means you wont necessarily spend on a new garage door. Buying a house, sure, but leave some of the interior decorations for another time, including the new dining set! Again, you get the point. Wallet size starts to grow, but previous experience dictates you don't want to overstretch. At this point breakouts are the only serious playable idea. New highs are rewarding. Companies that disappoint will not reward capital. Russel 2000 likely outpaces SPX

Phase III:The real fun is Phase III. The shackles now come off. You can see behaviour change dramatically, spending habits change dramatically. New kitchens are the norm (2007). Buying Internet stocks on monday to sell on friday to finance a boat on saturday (1999). Clamouring for Conglomerates (1987) becomes the dinner party conversation. There are sizeable wins to be had from such behaviour with equivalent pitfalls to avoid at the same time. Do not be afraid to enjoy these times, they are fun, but it's time to be a little more prudent as you were successful in Phase I and II. Chaos trading as Russel 2000 will likely outpace SPX to start then turn tail as growth prospects start diminishing.
The illustration below is an excellent representation of the above from Fidelity....

 

The most interesting part of cycles is you dont have to be an expert to see them. If you look around and take the temperature of behaviour, there is every chance that your experiences are just as good as reading from a text-book or listening to an "expert". There are plenty of "Cycle Theories" ranging from Kondratieff, Fractals, Cyclical, Secular, 17.6year cycle, Elliot Wave, Fibonacci to name just a few. All have their merits and followers, most will work when back-tested and with hindsight! Be warned, there isn't a magic bullet and nobody has a dominant success rate.

The most wonderful time in cycles, as in life, is when you find yourself looking to the stars rather than staring at your feet. It's an uplifting feeling when you finally make that transition, as most will atest.

Queen takes Pawn

Why does the Yield curve matter?

Kids, you don't know what you don't know, until you know it!

Way back in the early 2000's a colleague pointed out the yield curve to me. What was the yield curve? The difference in yield between 2's and 10yr US Treasury debt. We discussed at length what it meant and how we might be able to use it. 

The Curve.

It is as cyclical as the market itself. Almost rhythmical. It has a habit of defining cycles. 

In essence it's primary use is for lending institutions to build balance sheets easily. Borrow short term money cheaply to lend it for a longer period, capturing the spread between the two yields. Simple enough. Remember the Fed are involved when it comes to a steepening or flattening curve.

Here is the longer term chart of yield curve vs SPX.

Steepening Vs Flattening Curve

So, as the yield curve steepens, you can bet your bottom dollar that financial institutions are making money. Conversely when the yield curve flattens it's likely that financial institutions are sacrificing some yield for more volume as the economy grows.

The cool part

When the yield curve finally moves from an inverted state and steepens for good, you can count the days to a stock market correction.  

I'll show you......

There are times that the yield curve has been INVERTED. This happens when 10yr yield is lower than 2yr yield, giving a negative carry (not being able to borrow short term at advantageous rates to lend longer term).

There are many and varied explanations as to why this happens, the most important thing to note is you are at the end of a bull market and are about to witness a bear market. The length of that Bear market changes according to circumstance. It's a strange sensation. You can see the yield curve steepen for good in 1990 that coincided with a correction in stocks, and in 2000 and, you guessed it, 2007!

1990

2000

2007

Implications of yield curve.

As you see flattening of the curve, there really isn't a concern as a goldilocks scenario exists in the markets. Once you enter an inverted phase, pressure starts on financial institutions to make money in other ways. They do this by increasing their risk profile for activities. At some point that inevitably comes unstuck. Call it bad financing of S&Ls, Internet incubators, Housing, Subprime!

This is a big red flag, do not attempt to outsmart the market or get caught up with a scenario that you lose because others are placing larger bets, what follows is a little chaos. You can see exactly what happens in 1987-1992, 2000-2002, 2007-2011.
As the yield curve is inverted, markets have a habit of rallying, the usual amount is about 6%. Use this time to build your cash positions, be at peace with your wins and your losses, do not over trade. There is an ill wind on the horizon. Timing this ill wind will be tricky, but there is one move that matters beyond any else.

WHEN THE YIELD CURVE FINALLY STEEPENS FROM AN INVERTED STATE, YOU CAN COUNT THE DAYS TO A CORRECTION.

Playing this on the short side can pay handsome dividends, however you will not sleep well as a bear has claws and all positions are subject to daily fluctuations that will force you out of your trades. You can also just be long cash which is a synthetic short as you expect cheaper prices.

These trends are very large and do not end without an awful lot of hardship and business's failing. 

This is your time to be humble and help those that are less fortunate than you. Many will ask for some help, offer it freely and with good grace. You had the benefit of reading this, they did not. 

Use the time of market uncertainty to assess its pulse. Use the steepening curve to understand that financial institutions will become healthy once more, no matter what the media says. When the market looks like it can't get any worse, likely doesn't! Lows have been marked by the starting of Wars, the inability of Governments to act or an Institution failing. The market will start discounting bad news and rally when everything points otherwise, be aware. This is a necessary healing process. You can benefit in the same way as before, allow the market to guide you on your journey.

Buy innovation, be brave. Some will not work out, keep your losses small, it is the gift of discipline. 

Never be afraid to re-enter the same trade, just understand your entry price. Some of the best companies in the world have suffered some short term setbacks.

Once the curve has steepened and the stock markets rally on bad news, you will notice something phenomenal! You are on the right side of the market and the Fed are helping you! That is a powerful friendship to have. 

Study the charts of leading stocks, they can guide you. No need to be too short term on your thinking, that is for others. Enjoy the peaks and troughs as the world really is a wonderful place. Keep your integrity, honour and discipline, it is yours alone.

Queen takes pawn.

First musings for my children......

Blog number 1. Some basics.....

THIS BLOG IS INTENDED AS A RECORD OF MY THOUGHTS ONLY, TO BENEFIT MY CHILDREN.

1) Stock markets are difficult to navigate, lets not over complicate a complex issue.

2) It's a bull market and has been since Oct 2011, in my opinion.

This particular bull run has been difficult to stay seated on. At every turn we are told "the next leg lower" is around the corner. At some point that will be true, the real trick is timing. In the meantime, learn the rules and play the game.

The term "blue-sky" trading applies to being long stocks that trade at new highs, this allows wins to be garnered from market intelligence rather than trying to outsmart the professionals. Some call it momentum, I like to think reading a market correctly is as difficult as an other subject.

3) Bear markets are notoriously difficult to capture from start to finish. Don't try to predict it, let the market show you the way.

4) Yield Curve matters. (gives bear market signals religiously)

5) Capex matters (gives bull market signals religiously)

6) Rotating sectors matter, rotation within sectors matters. (trends can be see consistently)

7) Action matters over price. True bull markets never allow you the re-entry price you are looking for do not make the mistake of always having to buy cheaper than you sold.

8) Swimming against the tide is absolutely fine. (2007 and 2012)

9) Swimming with the tide is absolutely fine. (2012-)

10) Be prepared to lose money and learn. Be prepared to make money and know not how.

11) Learning happens everyday, no matter your age

12) Position size is the most important part of sleeping well. (ask Mum about the 2007 short position)

13) Instinct matters. Trust it, it's yours and you worked hard for it.


I will post links in future as this blog evolves.......

Queen takes Pawn