Where are we in the market cycle?

Where are we in the market cycle? The accompanying chart shows a stylized market cycle and changes in sector leadership.

  • Bear markets are characterized by the leadership of defensive sectors such as healthcare, consumer staples and utilities.
  • Early-cycle markets are sparked by the monetary stimulus or the promise of monetary stimulus. The market leaders in this phase are the interest-sensitive sectors such as financials and real estate.
  • Mid-cycle markets are characterized by economic expansion. Expect rotation into consumer discretionary stocks, followed by capital-intensive industrials and technology.
  • Late-cycle markets will find investors become increasingly concerned about inflation. Inflation hedge sectors such as energy and materials lead during this phase.
  • In response to rising inflation expectations, either the central bank or the market tightens monetary policy, which resolves in a market top and a bear market.



Please be aware that while the psychology of a market cycle parallels an economic cycle, they are not the same. Since Wall Street’s attention span approximates that of a 16-year-old, it is not unusual at all to find several market cycles compressed within a single economic cycle.


What I have described is an idealized market cycle. This economic and market cycle is very different from others. The last bear market was not sparked by monetary tightening, but the exogenous effect of a pandemic. The market leaders of the 2020 bear were not the usual defensive names. Instead, investors piled into work-from-home beneficiaries consisting mostly of Big Tech stocks.


With that preface in mind, where are we in the psychology of the market cycle?



A late-cycle advance

Signs are accumulating that both the psychological backdrop and market action are pointing to a late-cycle advance. The latest BoA Global Fund Manager Survey found that respondents believe inflation is the biggest tail-risk facing investors.



In response, global institutions have rotated into inflation hedge vehicles.



Indeed, commodity prices have staged upside breakouts to fresh highs. The strength isn’t just in the energy heavy headline commodity indices, but the equal-weighted commodity indices too. 



The acute shortage in some commodities has been insane. As a consequence, backwardation of the futures curve. Normally, most futures contracts are in contango, with futures prices slightly above the spot prices with the difference reflecting the storage and carrying costs. Backwardated markets have the spot price above the futures price, which indicates a physical shortage. As an example, the one-year contango in December oil futures have completely blown out.



The shortages can also be found in commodities other than crude oil. The LME announced emergency measures to ensure “orderliness and continued liquidity” in the copper market by setting limits on the nearest-term spreads and allowances for holders of some short positions to avoid physical delivery. 



Inflation: This too will pass

Before everyone gets overly excited about a commodity bubble, the strength in commodity prices is attributed to – you guessed it, supply chain difficulties and their ripple effects. Goldman Sachs commodity analyst Jeff Currie explained the problem in a recent Bloomberg podcast.


It starts in China, coal in China, and then that creates tightness in gas that created the problems in Europe — Europe substitutes into oil, creating the problem in oil. You’ve shut down the (aluminum) smelters, the zinc smelters, you know, so a lot of people say, you know, that the ground zero of those problems really was coal in China. So I do want to say the situation in China is very dire, but it’s just one part of the world that can create a solution to it rather quickly and they’re trying to with investments in Mongolia. But I want to be careful about restarting a lot of that shuttered coal. For those of us that are Americans and know what a superfund site is in the U.S., restarting these facilities is going to be a lot more difficult, a lot more expensive than I think what people think it will be. So you really got to focus on the new, more cleaner, sophisticated coal, in some of these mines in places like Mongolia. So bottom line, it’s going to be tight over the next three to six months, but once you get that Mongolian coal up and running, the situation should ease, but no way does it solve it.

The root cause of the current spike in inflation indices is a demand-pull problem attributable to supply chain bottlenecks. When an economy exhibits too much demand and not enough supply of goods, inputs and workers, inflation is the result. Tighter monetary policy will not create more natural gas, copper, shipping, and trucking capacity. It is fiscal policy that can play a greater role.


Stephanie Kelton, one of the leading proponents of Modern Monetary Theory (MMT), wrote a NY Times Op-Ed in April on how to think about inflation in connection with fiscal policy, specifically Biden’s Build Back Better plan. In short, it’s all about the capacity of the economy to accommodate demand in the face of fiscal stimulus.

The key to responsibly spending vast sums of money lies in carefully managing the economy’s real productive limitations…


Depending on how big Congress ultimately decides to go on infrastructure, and how quickly, it may need to unleash a whole suite of inflation-dampening policies along the way…


These mostly non-tax inflation offsets could include industrial policies, like much more aggressively increasing our domestic manufacturing capacity by steering investment back to U.S. shores, using even more ‘carrot’ incentives like direct federal procurement, grants and loans, as well as more ‘sticks’ like levying new taxes to discourage the offshoring of plants. Reforming trade policies is another option: Repealing tariffs would make it easier and cheaper for American businesses to buy supplies manufactured abroad and easier for consumers to spend more of their income on products made outside of our borders, draining off some domestic demand pressures.
Despite the recent inflation angst, I am still on Team Transitory. I have shown before how the inflation surge is explained mostly by strength in durable goods demand as people began to work from home and switched their demand from services to goods.



The University of Michigan consumer survey shows that the buying conditions for durable goods is falling as prices rose. It’s difficult to see how the current inflation surge could sustain itself if households demand falls in response to higher prices.



Already, we are seeing signs of the transitory nature of the spike in the data. Monthly inflation rates topped out during the April-June period and have been moderating ever since.



What about inflation expectations? Some Fed speakers and investment strategists have voiced concerns that inflation expectations could soar and become unanchored, which would create the psychology necessary to spark an inflationary spiral.



Expectations is a red herring, according to a research paper by Fed researcher Jeremy Rudd. He concluded that policy makers should focus on reported inflation rather than expectations. Rudd’s paper also contained a controversial footnote that dismissed the economics profession in the context of forecasting.


I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.
A separate Cleveland Fed study found that the accuracy of forecasted inflation fell dramatically as the time horizon lengthened. While the long-term record from 1986 was reasonable, the recent record starting in 2011 showed that the accuracy of inflation forecasts fell dramatically within two months and was virtually useless past a six-month time horizon.



The market is setting up for a mistake in its inflation and interest rate expectations. Fed Funds futures are indicating a rate hike by the July 2022 FOMC meeting and a second increase at the December meeting. These expectations are likely too aggressive.




Why are stocks rising?

In light of rising expectations for rate increases, why are stocks rallying? Rate hike expectations are being pulled forward and economic growth expectations are falling. The Atlanta Fed’s latest Q3 GDP nowcast has tanked to a minuscule 0.5%.



John Authers at Bloomberg attributed equity strength to TINA – RIF:

How to explain this? TINA (There Is No Alternative — to stocks), appears to have morphed into her fearsome sister TINA RIF (There Is No Alternative — Resistance Is Futile). With yields low and inflation on the horizon, bonds are regarded as unbuyable. 

To be sure, Q3 earnings season has been strong. Earnings estimates are rising and beat rates are above average. Strong positive fundamental momentum is supportive of higher prices.



All else being equal, rising EPS estimates allows the forward P/E to fall, which is supportive of valuation and stock prices.




The transition process

At some point in the near future, the market will begin to recognize the transitory nature of the inflation surge. Bonds will no longer be unbuyable and yields will begin to ease. That will mark the transition to the next phase of the market cycle.


This next phase will be marked by a leadership rotation from late-cycle inflation hedge and cyclicals back to growth stocks. Growth companies are duration plays and they have the greatest sensitivity to falling bond yields.



I don’t expect a recession-induced bear market during the transition. Recessions are bull market killers, but there are few signs of a recession on the horizon. New Deal democrat, who monitors the economy using coincident, short leading, and long leading indicators, remains bullish on the economic outlook.


All three time frames remain quite positive. Delta continues to recede, and the impact – if any – of the ending of all remaining emergency pandemic benefits last month has been limited.
However, the economy is likely to see a growth scare next year, which could spark a correction.

There are many signs in data that the white-hot Boom is cooling. But nothing to indicate it is actually in any danger of rolling over in the immediate future.

My base case scenario calls for a stock market rally into year-end led by reflation stocks. We are entering a period of positive seasonality and the market has been tracking the seasonal pattern relatively well in 2021. Expect a growth deceleration soon afterward, a rotation into growth, and a possible correction in Q1, but no bear market.


While it’s impossible to precisely forecast the timing of the inflection point, I can offer the guidepost of the 10-year Treasury yield, which has tracked the value/growth ratio closely in the last two years. If the 10-year yield starts to fall in a decisive way, the rotation from reflation and value to growth has likely begun.


12 thoughts on “Where are we in the market cycle?

  1. $120 Billion a month in Fed QE is floating all boats. That is the supply chain that matters. That level of QE is meant for extremely bad economic times and instead we are in boom conditions.

    People are spending all the government handouts that they were shut-in and couldn’t spend. That is demand inflation.

    I think wage expectations are more important for sustained consumer spending than inflation expectations. We are seeing strikes and voluntary company wage hikes (see Amazon). People who have wage hikes now and expected, buy more and borrow more as well as being less price sensitive.

    Most investors and market strategists have not been in an inflationary economy. The 1970’s experience is forty years ago. That suggests to me, that they will underestimate the possibility of inflation becoming a continuing problem.

    I try not to make predictions and rely on my momentum research to show where things are going. Right now, it is in the inflation/higher rates camp.

    Here is an interesting article;

    Analyst Who Exposed Libor as Broken Warns of Rising Rate ‘Tsunami’ https://www.bloomberg.com/news/articles/2021-10-22/ex-citi-analyst-who-exposed-libor-as-broken-sees-rate-tsunami

  2. From what you have written, we seem to be close to a market peak and it behoves to cut back on equity exposure, going forward and raise cash in portfolios. Sure, it may take unto Q1 for this blow off peak to develop. That would be ample time to reduce exposure to value, commodity, financial, industrial and material complex and increase growth exposure.
    Increasing bond exposure, staples and utilities and big pharma for long term dividend sleeves seems to be what seems to be the plan, in the next few quarters.
    Switching gears like this is painful (and tax inefficient) and I suppose increasing exposure to VTI should be in order, for a catch all ETF.

    1. When the inflection point comes, I don’t expect much more than a 5-10% pullback.

      Is that enough to get really defensive? I don’t know your pain threshold. 5-10% represents normal equity risk.

      1. Thanks. Yes, 5-10% correction is par for the course. The question remains when and if to switch value overweight to tech/growth overweight, and when.

  3. An obvious cause of inflation that nobody seems to emphasize, because it is politically incorrect, is the Biden/Environmentalists energy policy which has added to fuel to increased LNG & all energy costs. Another factor that deserves discussion is the large cohort of people born in the late 1980s & 1990s that are starting to form households. The peak demand and earning/spending cycle for this group is going to effect the demand side for the next decades. Inflation is not transitory.

    1. I think a key variable in the climate change debate is how willing south east Asia is going to be in adopting “green” policies. Maybe we are going to remember Friday as the day that Powell shifted his policy stance on inflation.

    2. The demand from people born in 1980s and 1990s is probably getting offset by the loss of demand from a much larger cohort of Boomers who have been retiring in droves.

      There has been significant underinvestment in energy and basic materials under the prior administrations because the market prices for those commodities were too low to justify the investment. Can’t blame Biden for low prices. Investors were just too enamored with Big Tech and Bitcoin!

      However, if the Biden/Environmentalists do not have a plan to erect renewable sources fast enough to offset the declining energy from fossil fuels and new demand from EV, yes, we should blame them. Unfortunately, that’s where we seem to be headed.

  4. I think at the heart of ESG is NIMBY, or it’s cousin.
    It’s all fine an nice to go green, but what is Germany doing? Burning coal….so when the fan needs cleaning, people do what they do….when ESG leads us to an oil shortage in 5 years, who gets blamed?
    Contrarian position is to invest where ESG does not want to go…because these will be the unloved underpriced sectors….Dogs of the Dow was a method of investing that supposedly worked, also contrarian.
    So when it comes down to not starving or freezing , people will buy whatever however it is made food and burn whatever they need to stay warm….those who don’t agree starve or freeze to death

    1. So, coal (and oil & natural gas) might be gold over the coming years but nuclear will be the comeback kid.

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