The Perils Of Maturing To Late-Stage Expansion Cycles
Do you remember when you were a kid and your mom screamed, “Reid [your name may be different], I thought I told you to sweep out that garage!?” And, of course, she had, about three months prior in fact, and several times since then. “Sure Mom,” you replied, and then resumed “condition tune out.”
Yes, you continued to ignore her until finally, one day, it was a seismic event: “Reid, I told you to sweep out that g-d*****#$ garage and I’m not kidding! Get your fat *4# down there and do it—NOW!!”
Two things were in play in the development of that vignette. The first was that your mom told you to do something, and you paid a disrespectful level of attention and let it go in one ear and out the other. So your mom became impatient and irritated over a period of several weeks—and rightly so.
But the coup de grâce was the result of an additional factor. That was when an event occurred that your mom specifically attributed to your inattention, insubordination and consequential negligence, and that’s when she lost her composure about the matter. That was the day your mom drove into the garage, and because there were nails and broken glass you hadn’t swept out (left there by some project you were working on, during which you had also dropped a bottle of soda you hadn’t cleaned up after), a tire on your mom’s car was punctured, and the next time she had an appointment to get to, she discovered she wasn’t going to make it on time because she had a flat tire you could have prevented had you been a good and obedient son instead of a typical American boy (with, in your judgment, more important things on his mind).
It is astonishing how such moms become, in one form or another, the chief executives of Wall Street’s largest firms, and also how their subordinates are the same boys who never grew up and are still ignoring orders to sweep out the garage until one day there is a seismic event.
The Seismic Event
We had such a seismic event toward the end of last year, a decline in the market that culminated with a large selloff on December 24, and leading up to that big day there was quite a drama over an extended period of time with the President of the United States suggesting that the Chairman of the Federal Reserve Board might have a mental health problem. And meanwhile, those disobedient boys on Wall Street had failed to heed their moms’ repeated reminders to sweep out the garage.
And BAM!, as Chef Emeril on television likes to exclaim when he’s either “taking it up (or down) a notch” or selling you his cookware or appliances, this is what is called a rotation, and it is very typical of changes in phases of the business and stock market cycles. And, very frequently, at critical points in time, there is a flat tire in the garage because disobedient boys didn’t sweep it out when they should have, and this causes big problems sometimes culminating in rolling heads as portfolios get caught unprepared.
I lifted the following infographic from Charles Schwab off the web. It’s a rough rendering of one version of business and stock market cycles and the corresponding industry sectors and segments favored within each:
Typically, finance people like to say that a business cycle ends with the Fed killing the economy, raising rates due to worries over inflation, and a lot of that is related to wages and employment in the construction sector, especially residential housing, because that activity is labor intensive, well paid and has widespread and quickly rippling effects “butcher, baker, candlestick maker”-style as rising rates promptly stifle housing starts with mortgage capital becoming more expensive and less available. One well known economist I used to work with sometimes called this a process of the Fed “drafting inflation fighters” in its war on inflation.
But that was a very long time ago. There are still business and stock market cycles, but we do not have housing start rates fluctuating between a million and a half and two million annually as a “normal band” in a healthy economy with mortgage rates of seven percent on their way up to 15 percent. But that is the way it was in the 1970s. Hard to believe, isn’t it? Inflation was a serious concern then as well.
Things Have Changed
Today things are quite a bit different. The whole economy is much less labor intensive, thanks in large part to technology. The labor sector is also far less organized/unionized (in the private sector, that is), and therefore, there isn’t massive wage inflation coming around like an unexpected hurricane when full employment is approached, and therefore also less of the vicious cycle effect of rising wages begetting higher prices, with the latter then feeding back to the former, and so on. Housing starts are hot if they are over a million these days. In the 1970s that low a number would have been considered very severe recession conditions.
The point is, that as the economy progresses through the stages of an economic cycle, the picture changes as to what is going on in the economy: what is happening to wages and prices, what the Fed is keeping its eye on…and, oh yes, those negligent garage sweepers on Wall Street who are supposed to be getting ready to rotate from the current artist’s palette of equities to the next. But, guess what? Often those boys who ignored their mothers are STILL not on top of that job. Hence, portfolios and performance get caught by surprise, and this can happen very suddenly and quickly as it did at the end of last year.
Cycle Dynamics
What exactly is going on as we progress from one stage to another in the cycle? Remember, a new cycle starts following a recession of some varying duration caused by the Fed killing the previous cycle. The recession is the result of those high rates the Fed uses as “the bullets in its gun” to bring down inflation when they think the risk to employment is lowest and the priority of price stability becomes relatively more important a consideration. And, as the economy dies, rates eventually come down as credit appetite abates.
So the cycle starts with diminished activity and low rates. This is when, allegedly (according to cycle theory), it makes sense to start accumulating interest-rate sensitive issues in the stock market. Consumer discretionary, financials and real estate are on this list because they are direct beneficiaries of “money put on sale.”
Then the economy starts to get going again, and works its way through technology, energy, healthcare, industrials, as the economy heats up and demand for things like washing machines and cars begins to pick up. The culmination is incipient signs of “overheating” as full employment approaches and consumer and industrial demand get stronger still. This so called maturing/late cycle expansion stage includes earmarks of luxury purchases (technical analysts will keep their eyes on Tiffany, for example, at this point in time) and other “big ticket” discretionary expenditures (meaning things you don’t need but buy anyway because you have some cold simoleons burning the proverbial hole in your pocket). This is when the leisure and travel industry picks up, such as people going golfing, attending concerts and taking expensive vacations. And, before long, housing starts rise, construction workers are everywhere working lots of hours at nice wages and inflation starts to heat up again.
Bingo! Time for another inflation fighting draft notice from the Fed to fight the inflation war, and up go the rates and the economy is brought down to size sufficient enough to put some number of those high wage interest rate sensitive home construction workers out of work and, through the ripple effect of losing their wages, kill the demand pushing up prices. Another cycle chalked up to history.
Well, that was the old story, 30 years ago or so, but things have changed quite a bit. We still have business and stock market cycles, of course. But some very important things have changed. One, inflation has become much less of a factor. Why is that? Well, consider globalization, aka outsourcing. China exports disinflation as we substitute their low wage labor and cost structure for what used to be our own here at home. Then there’s technology doing things that used to be done by people.
Those Darned Young People
There’s also huge changes in consumer tastes, likes and dislikes. Technology has served these transitions, such as Uber and Lyft putting cars on the road that would otherwise be parked on the street or in the garages you didn’t diligently sweep out, and so efficiencies are gleaned in the productivity of existing rolling stock. What does that mean? It means an abatement in what otherwise might have been a higher incremental demand for cars as larger percentages of existing transportation capital roll at any given moment instead of sitting idle. Millennials, it is said, aren’t so interested in purchasing cars as their forebears.
The Fed itself has different priorities too. We just mentioned how the auto industry demand has fundamentally changed and, lo and behold, back during that mortgage meltdown (2007 – 2009), it’s almost lost in the sauce now that we had to bail out the auto industry as well as the financial industry. So the Fed isn’t just juggling a balance between employment and price mix optimum, it’s juggling the viability of the industrial and financial sectors themselves. Many are vocally complaining now that the Fed is aiming its focus on the price of stocks instead of managing the economy. In fact, President Trump himself was rather annoyed that stocks were tanking when he complained about Mr. Powell not doing what he wanted him to do.
Then there’s this American – Chinese trade war, Brexit, deteriorating economic conditions just about worldwide (maybe Scandinavia has escaped)…not to mention the excruciating elephant in the room no one ever seems to notice called DEBT. Debt of every kind, from what government deficit spending piles up, to consumer debt to corporate debt. And other huge liabilities for public and private pensions and benefits and so on. And a good part of the corporate debt is based on the calculation that with interest rates this low, it makes more sense to borrow to buy your own stock back than it does to invest in capital expansion, and demand for product to justify that is in any event not bumping up against capacity expansion. And do you think anybody who is aware of the implications of trillion-dollar American government deficits as far as the eye can see feels comfortable about debt like that accreting at such a pace also being let out at interest rates in the 1970s range vs. today’s?
Cycles Themselves are Different
So yes indeed, cycle characteristics and policy priorities have changed quite a bit, and with those changes, so have the kinds of industry segments that populate the stages of stock market cycles. Financial experts are always warning us not to think or utter the words “it’s different this time” but they usually agree that while history may not exactly repeat itself, it usually rhymes. I would term it as something akin to listening to Steely Dan’s “Kid Charlemagne” back in the 1970s. Yeah, you can definitely recognize the modern sampled rap versions, but sometimes you can’t tell if it was meant to be like that, or the result of a CD that got left in the dishwasher.
So here we are now in the post-Powell capitulation phase wondering what the current very busy rotation is bringing us, broom in hand and ready to sweep out the garage instead of ignoring our moms.
For a baseline, here is the current state of affairs according to a few ETFs I keep a vigilant eye on:
By way of comment on what happens when you don’t keep up to date with your garage sweeping, please note that when Chairman Powell was still laboring under the pre-Trump scolding misconception that he was going to increase rates and roll a lot of the Fed’s balance sheet holdings off, the staples and utility sectors were not trading at such substantial premiums to their long term moving averages. But December 24 was that flat tire in the nails and broken glass that changed that.
Why Financials Lag
You will note that financials ain’t doing so hot. This is a secular as much as a cyclical problem that began with 9-11 and was greatly exacerbated by the 2007 – 2009 mortgage meltdown. It also greatly affects the midcap sector because much of that group is financial companies. Simply put, when you keep interest rates low, you can’t make a lot of money in the lending business. Not only that, but serious and largely uncommented upon transitions have occurred in the mortgage business. It used to be Morgan-Chase, Wells Fargo, BOFA and Citi holding 50% of the outstanding dollar value of those loans.
Now, Wells Fargo is the only one left on that list at the same level. Rocket Mortgage and U.S. Bank are among the new giants taking their place, many of which are now nonbank lenders, meaning they don’t take deposits and thus escape a lot of regulation. And guess who lends them money? That’s right, the big guys that used to let out the mortgages directly. It’s a crazy world.
The RLH Volatility Model is something I created for the express purpose of rotational considerations. I will leave for another time a discussion in greater detail of how it works, but to make a long story even more boring, let me just say for now that my theory of volatility is encapsulated in the model by the “wiggle” of stocks, which is to say subjecting stock trading history to numerous tests about their intraday price and trading characteristics over very long periods of time.
Here is the model’s current positioning of the sectors noted above:
RLH volatility model as of 3.25.19: