Summary

Costco’s price pattern is closely related to the business cycle.

Costco outperforms the market when business slows down.

Costco has declined enough to make it attractive again.

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As shown in my article of 12/15/2020 - Costco: A Great Defensive Play, The Issue Is Timing – Costco has distinct pattern closely tied to the business cycle.

Costco declined more than 19% from December 2020 to March 2021. It has underperformed the market from March 2020 to March 2021. Its price is now at the levels of last December. 

The price action of Costco raises two questions. Is Costo likely to outperform the market? If so, what is its price action telling us about the future of the business cycle? 

The importance of knowing where we are in the business cycle has major implications on what type of stocks should be in a portfolio.

                                Source: The Peter Dag Portfolio Strategy and Management

There are two crucial turning points of the business cycle. The first one is when business transitions from Phase 2 to Phase 3. The second point is when the business cycle moves from Phase 4 to Phase 1. Both points signal important changes in price performance of the major market sectors as discussed in detail here.

In Phase 2 of the business cycle business is facing strong demand and needs to replenish inventories to meet sales. The increased production is achieved by buying more raw materials, hiring more people, and increasing borrowing to expand and improve productive capacity.

The outcome of these decisions is higher commodity prices, rising wages, and higher interest rates. The combination of these factors is transmitted to the consumer as higher inflation.

In this phase of the business cycle commodity-sensitive stocks, industrials, energy, and financial stocks easily outperform the market. 

The reason for this scenario to come to an end is rising interest rates and inflation have a negative impact on consumers’ spending power. The outcome is slower growth in demand resulting in unwanted inventory accumulation.

There is a point when business finally recognizes the economic landscape has changed and inventories need to be cut by reducing production. 

The implication is buying raw materials needs to be curtailed, the workweek needs to be cut, and borrowing must also be reduced. These decisions will cause lower commodity prices, slower growth in wages, and lower interest rates. This is the time the business cycle transitions into Phase 3.

Beginning in Phase 3, sectors outperforming the market are utilities, staples, real estate, and bonds.

The current position of the business cycle is in Phase 2. The recent sharp rise in inflation, commodity prices, and interest rates suggests we are close to the Phase2-Phase 3 turning point.

The price pattern of Costco compared to the S&P 500 is particularly telling because it might give further information on the position of the business cycle.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows two panels. The graphs in the above panel represent the ratio between COST and SPY. The second graph is its 200-day moving average. The graphs rise when COST is outperforming SPY. The graphs decline when COST underperforms SPY. Investors are going to outperform the market if they invest in COST when the graphs rise.

The bottom panel shows the spread between the ratio COST/SPY and its 200-day moving average. The resulting pattern is unique and quite interesting.

The first feature is the spread has now reached “oversold” levels (red horizontal line), signaling the beginning of a period when COST outperforms the market. 

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The second intriguing feature of the graphs is the spread is closely related to the business cycle as shown by the above graph. The spread between COST/SPY and its 200-day moving average is shown in the upper panel.

The lower panel shows our business cycle indicator updated in each issue of The Peter Dag Portfolio Strategy and Management available at www.peterdag.com. 

The interesting feature of the chart is the bottoms of the spread coincides with a peak of the business cycle. A peak of the spreads takes place when the business cycle bottoms.

The message is, and this should not be a surprise to the readers of the article published here, COST outperforms the market when the economy slows down.

Key takeaways

The transition of the business cycle from Phase 2 to Phase 3 signals the need to rebalance the investment portfolio.

The sharp increase in inflation, interest rates, and commodities we have been experiencing suggests we are close to the Phase 2-Phase 3 turning point of the business cycle.

The ratio COST/SPY has reached oversold conditions, coinciding in the past with a peak of the business cycle. These oversold conditions suggest Costco will continue to outperform the market.

The strength of Costco compared to the market may suggest investors are beginning to position their portfolios for the Phase 2-Phase 3 turning point of the business cycle.