Sell ​​high beta stocks. Buy low volatility stocks. It’s the economic cycle

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There are three main types of economic indicators: leading, coincident and lagging. Lagging indicators are most important to investors because they determine the length of the business cycle and the severity of the economic correction needed to bring them down so the economy can grow again.

Inflation, interest rates and labor costs are the most important lagging indicators. A rise in inflation reduces the purchasing power of consumers. Rising interest rates make purchases of everything less affordable, especially housing and automobiles. Rising labor costs are hampering profitability. Consumers react to rising inflation and interest rates by first reducing the purchase of big-ticket items. This is also the time when the University of Michigan’s consumer confidence drops sharply.

Slowing home and auto sales are early developments reflecting the slowing economy. These slowdowns are reflected in stock prices. Coincident indicators such as employment and sales are also starting to tumble.

The opportunity to invest in equities arises when the leading indicators – those that were the first to signal the slowdown – will pick up.

One of the most important tenets of the business cycle is that the downturn will continue until the causes that created it are brought under control.

The main causes of the slowdown are the rise in the main lagging indicators: inflation and interest rates. The slowdown will continue as consumers cut spending until their purchasing power recovers. This happens when inflation and interest rates go down. This is also the time when labor costs decrease, improving business profitability.

As retail sales increase due to increased consumer purchasing power, the other coincident indicators also increase: employment, production and income. These developments will strengthen and the positive loop will continue until the economy overheats.

This is the time when the lagging indicators rear their heads and the business cycle begins again.

Where are we now?

Lagging indicators are up. Consumer prices continue to rise – up more than 8%. Interest rates – both short-term and long-term – have reached new highs for this business cycle. The yield on the two-year Treasury rose from 0.2% to 2.6% over the past 12 months. The stock market, an important leading indicator, is showing no gains since June 2021 at the time of this writing. Auto and home sales weakened after several months of rising inflation and interest rates.

Consumers reduce spending on big-ticket items first when income after inflation declines, as it is now (see University of Michigan survey shopping conditions charts below ). In other words, an increase in lagging indicators (inflation and interest rates) leads to a spike in consumer buying conditions of the leading indicator (see chart above).

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