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Tuesday, June 07, 2005
Market Recap
Stocks opened higher today with a triple digit gain early on in the DOW on comments from Chairman Greenspan but as time went on during the session, the rally faded slowly. By the end of the day, the DOW gave back almost all its gains, closing up only 16 points. The NASDAQ lost 9 points after being up over 20 points. The S&P closed down less than a point but the key here was that is that it closed back below 1200 and with an ugly reverse hammer candle and closed near the LOD. It was a very disappointing day for the bulls because of the sharp reversal after being way up at the open. Tonight's commentary is on the business cycle and it is by an email request. It is rather extensive, in order to properly explain it all. As a result, there is only one chart tonight and it is the only stock that you need to own in this market right now.
The Business Cycle
Certain sectors of business profit more in certain stages of the economic cycle. This cycle can provide a road map to traders as to how to trade each sector during each phase of the cycle. Tonight we will take a look at this and see how we can profit from the business cycle and sector rotations. Sector rotation is an investment strategy that involves moving money from one industry sector to another, during the various stages of the business cycle. A business cycle is the recurring and fluctuating levels of economic activity that an economy experiences over a long period of time. The five stages of the business cycle are: expansion, peak, recession and recovery. At one time, business cycles had very predictable durations but now business cycles are irregular, varying in frequency, magnitude and duration.
Recession
A recession is a significant decline in activity across the economy. A recession generally lasts from 6 to 18 months and, by no coincidence, is how long Bear markets generally last. A recession is visible in industrial production, employment, income, and wholesale-retail trade. The first sign of a recession is two consecutive quarters of negative economic growth, as measured by our Goss Domestic Product. Since 1945, the U.S. economy has experienced 11 recessions and 10 expansions. We are currently in the 11th expansion but if Greeny keeps raising rates, we may be approaching our 12th recession soon.
There are statistics that show when expansions are divided into early, middle and late phases of equal durations, and when recessions divided into early and late periods of similar lengths. With a recession, a pattern of sector rotation and stock performance is apparent. It is important to remember that the past performance of stocks does not always mean future success following this cycle. A particular sector may or may not be in favor at any time, due to outlying factors. However, we have a road map of past performance and we can look at what has worked for stocks in the past.
Four Stages of the Stock Market Cycle
The stock market moves up and down with the economy. The four stages of the stock market cycle are:
1) Market Bottom - This is represented by falling stock prices, culminating in a long-term low.
2) Bull Market - This begins as the market rallies from the market bottom.
3) Market Top - In this stage, the market reaches a climatic top and the bull market starts to flatten out.
4) Bear market- We all know what this means, stocks start to decline in price and continue declining for months. This brutal slow bleeding keeps people in, hoping for a turn around. This turn around may not come until after they just cannot take it anymore and sell the last of their stocks in a climatic capitulation sell off. The bear takes a generation of new investors to the cleaners, wiping them out of the market for years, if not forever. It is only then that the market bottom comes and the cycle begins all over again.
We know the stock market attempts to predict the state of the economy 3 to 6 months into the future. That means that the stock market cycle is usually well ahead of the economic cycle. This is crucial to remember because as the economy is in recession, the stock market begins to look ahead to a recovery and vice versa; when the economy is peaking at the end of a business expansion, the stock market starts to decline. We may be seeing this soon, if the Federal Reserve keeps raising rates to slow down the economy.
Four Stages of the Economic Cycle
There are four basic stages of the economic cycle with some associated signals. Keep in mind that these usually trail the stock market cycle by a few months.
Full Recession - This is not a good time for businesses or the unemployed. GDP has been retracting, quarter-over-quarter, interest rates are falling, consumer expectations have bottomed and the yield curve is normal. Sectors that have historically profited most in this stage include: Cyclicals and Transports, Technology, and Industrials (near the end).
Early Recovery - This is when things are starting to pick up. Consumer expectations rise, industrial production is growing, interest rates have bottomed and the yield curve is beginning to get steeper. Historically successful sectors at this stage include: Industrials (near the beginning), Basic materials industry, and Energy (near the end).
Late Recovery -In this stage, interest rates can be rising rapidly, with a flattening yield curve. Consumer expectations are beginning to decline, and industrial production is flat. Here are the historically profitable sectors in this stage: Energy (near the beginning), Staples, and Services (near the end).
Early Recession -This is where things start to go bad for the overall economy. Consumer expectations are at their worst; industrial production is falling; interest rates are at their highest; and the yield curve is flat or even. Historically, the following sectors have found favor during these rough times: Services (near the beginning) and Utilities.
What Stage Are We in Now?
I believe that we are somewhere in between the end of late recovery and the start of early recession. I think the market was trying to forecast this before this recent rally. This is why I stated that we should be short cyclicals. I also mentioned, in a previous commentary, that the utility stocks are defensive stocks that would not be affected by a recession. You will see from the link below that this would be a correct strategy, if we are in fact headed into a bear market and recession. This recent rally has changed that outlook for now. This is proof that the market is trying very hard to predict the economic stage 6 months from now and by the recent up and down action; it is having a hard time with that task.
The Yield Curve
History has shown that inversions of the yield curve have preceded the last five U.S. recessions and bear markets. The yield curve accurately forecasts the turning points of the business cycle. If Greenspan keeps raising rates, short term rates will be higher than long term rates, and that is an inverted yield curve. This would certainly send stocks into a bear market. Right now, the yield curve is tightening and when this happens, the outcome is not good for the economy or stocks. If short term rates keep rising as Greenspan has led us to believe, the yield curve will certainly flatten or even become inverted. The Bears will have a party, should this development become reality.
A Picture is Worth 1000 Words
With this general outline in mind, we can try to anticipate which companies will be successful in the coming stages of the economic cycle. Watching for these signals can give great insight into which stage the stock market believes the economy is in. I have added a link from stock charts that will give you a picture of what I have just explained above. This picture is worth 1000 words and is something you should print and save for future reference.
One key point in the link below. Take a special look at the Energy sector. It normally tops out at market tops. Lately, energy stocks have been falling in price, like they are supposed to do during early recession. This is another clue as to where the market thinks the economy is headed. The Federal Reserve is the key, interest rates drive the economy. They must stop raising or they will put us in another recession. Everything I see happening on the economic front lately is pointing to a recession and a bear market and therefore, it is hard to be bullish from that stand point but right now, stocks are ignoring these facts and continue to rise, at least for now.
http://www.stockcharts.com/charts/performance/SPSe...
STHQ Chart Index
If you go to the chart index in the left side menu, you can review and study charts that we have annotated for each stock listed in the past.
For New Members
For all of the new members with us, please make sure to read the link “How to use Bulletin” at the bottom of the Bulletin page on the website. It is critical that you know how to use this trading tool before trying to trade the stocks mentioned. The effectiveness of your trades will diminish if you do not completely understand how the information is presented.
Earnings Calendar
We have added the earnings link for each stock on the bulletin. To access the link for earnings, you can either use the link below or click the link on the bulletin for the corresponding ticker. Click the online bulletin in the left side menu for access to the earning calendar for each stock listed. It is not recommended to hold a position through earnings. You can always buy the stock back after the dust settles.
http://www.earnings.com
Stockcharts Listing
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http://stockcharts.com/def/servlet/Favorites.CServ...
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