Options markets and economic cycle point to a bear market

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In my article from July 29, 2021 (here), the action in the options markets pointed to a bear market in equities. The purpose of this article is to also review the indicators discussed in the articles and examine what they say now.

The business cycle, earnings and the stock market

CYCLE BUS

Strategy and portfolio management Peter Dag

The business cycle goes through four phases.

Phase 1 begins when the company needs to replenish its stocks, realizing that their level is too low. The decline in inflation and interest rates that occurred in phase 4 improves consumers’ purchasing power and their propensity to spend. Production must increase to meet demand. Increased demand for commodities and financing to improve capacity puts a floor under commodities and interest rates.

Phase 2 reflects the increase in demand caused by increased employment and income. Businesses must now aggressively replenish inventory. In this phase, the economy overheats. Excess production puts upward pressure on commodities and interest rates, as well as inflation. Towards the end of phase 2, commodities, interest rates and inflation rise.

Phase 3 is a critical point in the economic cycle as growth begins to run out of steam. Rising inflation reduces the purchasing power of consumers. The University of Michigan survey reflects growing consumer pessimism about their finances and prospects. Demand is slowing. Rising raw materials, interest rates and labor costs are starting to have a negative impact on profitability. Inventories need to be reduced to reflect slowing demand and keep margins in check.

Phase 4 reflects the effect of lower production. Commodities, interest rates and inflation are now down due to weak demand and aggressive production cuts to bring inventory growth in line with demand. This phase will continue until consumers recognize that their purchasing power is improving. The University of Michigan survey shows that consumer optimism is on the rise.

Phase 1 is underway again.

The economic cycle is currently in phase 3, which suggests that we are much closer to a top than a bottom in the bear market and the economy.

Strategy indicator

Strategy and portfolio management Peter Dag

The chart above shows charts of the S&P 500 (SPY) in the top panel and the Business Cycle Indicator, published in each issue of Strategy and portfolio management Peter Dag, in the bottom panel. The economic indicator is calculated in real time from market data.

The chart shows how a decline in the business cycle indicator, reflecting a slowdown in economic growth, signals a period of weakening market conditions. A rise in the business cycle indicator, reflecting rising economic growth, indicates a strong stock market.

Earnings

Strategy and portfolio management Peter Dag

Periods of market appreciation or decline reflect the cyclical behavior of earnings. The chart above shows in the upper panel the earnings growth of the S&P 500. The lower panel shows the economic cycle indicator. The evolution of earnings closely follows the economic cycle. They rise faster when the business cycle indicator rises, reflecting stronger economic conditions. They slow down when the business cycle declines, reflecting weaker economic conditions.

Current trends in the business cycle indicator are down, indicating a slowdown in earnings growth.

The strategy indicator and stock sectors

In an article published on 02/29/2021 (here), the discussion focused on the behavior of the eleven sectors of the S&P 500 during several economic cycles.

Strategy

Strategy and portfolio management Peter Dag

The chart above shows our strategy indicator. The chart shows that the bottom of the economic cycle occurred in 2020 and the top in 2021. The probabilities favor the bear market at the bottom not before the end of 2022, possibly in 2023 if the strategy indicator follows the four-year historical cycle.

Sectors

Strategy and portfolio management Peter Dag

The chart above shows the performance of sectors against the S&P 500 during the decline of the economic cycle. As of October 2021, the strongest sectors are XLU, XLP, XLV and VNQ – excluding materials and energy. Cyclical sectors underperformed. This is a pattern typically seen when the business cycle declines, reflecting a weakening economy.

Sector action confirms that the economy is slowing as evidenced by falling business cycle indicators and suggests that the most appropriate strategy is to focus on defensive sectors.

The options market and the bear market

Choice

Strategy and portfolio management Peter Dag

The chart above is the updated version of the chart featured in the July 29, 2021 article. The top panel shows charts of the S&P 500. The bottom panel shows indicators calculated using options market data . This gauge is still falling and points to greater market weakness.

The system of leading, coincident and lagging indicators

Cycle

Strategy and portfolio management Peter Dag

The chart above helps to recognize the economic and financial conditions taking place at the bottom of the bear market. The charts above were also discussed in detail, including the implication for a bear market, in my October 26, 2021 post (here). The charts show the relationships between leading, coincident, and lagging economic/financial indicators over a business cycle.

For the purposes of this article, important leading indicators are stock prices, consumer optimism, commodities. The coincident indicators are income, production and sales. The lagging indicators are interest rates and inflation.

The chart above indicates that an economic slowdown (coincident indicators) is preceded by a slowdown in leading indicators. A slowdown in leading indicators is preceded by a rise in lagging indicators. Leading indicators rise on weak lagging indicators.

This is where we are now. Inflation and interest rates are rising. Leading indicators, such as the stock market and consumer optimism, react accordingly, with stocks and consumer optimism declining.

When will the trough of the leading indicators (stock prices and consumer optimism)? The start of a new bull market and the rise of the business cycle will occur when interest rates and inflation decline enough to restore consumer purchasing power and thus stimulate demand for goods and services.

Key points to remember

  • The business cycle is slowing, reflecting weakening economic conditions. These conditions have been aggravated by rising interest rates and inflation. Excessive accumulation of inventory to be liquidated due to slowing demand will cause further economic damage.
  • This is when defensive sectors outperform the market.
  • Earnings will continue to slow and stocks will continue to fall as the economy continues to slow. The economic cycle is at this stage (Phase 3).
  • The economic cycle will bottom out when interest rates, commodities, and inflation decline sharply enough to increase consumer optimism and increase purchasing power.
  • The new bull market begins as inflation and interest rates decline and consumer optimism rises again.
  • This is when cyclical sectors begin to outperform the broader market.
  • Historical patterns, such as the strategy indicator’s four-year cycle, suggest that the bottom of the business cycle and the stock market will not occur until late 2022.
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