Business Cycle And Sector Rotation - The Big (And Most Important) Picture

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Includes: DBC, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IEF, IVV, IWD, IWF, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV, XLP, XLV
by: Mitch Bulajic
Summary

We are at the end of stage 5 of the business cycle, waiting for commodities to drop and confirm start of the stage 6 of the business cycle.

We are at market top confirmed by consumer staples - consumer cyclicals spreads and value - growth spreads that are at historic lows and reversing.

Stocks are overbought and bonds have begun the second phase of the bear market, confirming the exact timing and patterns of stage 6 business cycle and stock market top.

10-year - 2-year yield spread is still on track to inversion where the spread and timing patterns predict the most likely reversal of the spread and recession in the second half of 2019.

Business Cycle Analysis

In my last article from January 2018 on this subject Inflation, Business Cycle And Sector Rotation - Domino Effect And Investment Opportunity, I wrote that we are entering phase 5 of the business cycle citing technical, sentiment and money-flow indicators that stood the test of time. Today, 10 months later, we are getting very strong and clear technical and money-flow signals that we have ended stage 5 and most likely if not already entered stage 6 of the business cycle.

Business Cycle Map - Courtesy of Stock Charts (StockCharts.com | Simply The Web's Best Financial Charts)

Let's take a closer look at the technical, money-flow and comparative analysis for Bonds, Stocks and Commodities and see how it stacks up with the business cycle theory chart above and the possible timing of these events.

Bonds - iShares 7-10 Year Treasury Bond ETF (IEF)

The bond market has been consolidating since July 2012 and reached a top on July 2016 and has since been in a first phase of the bear market. The price pattern resembles a head and shoulder pattern, where the start of consolidation in July 2012 is the left shoulder, top the July 2016 peak is the head top and peak in September 2016 is the right shoulder top.

I am particularly keen on the head and shoulder pattern, not so much on the actual pattern itself but on its support line, in this case, around the current closing price at 100, that is much more significant and stronger than any other arbitrary support lines (same goes for inverted head-and-shoulder patterns and its resistance lines), furthermore because this support line also happens to be a very strong 38% Fibonacci retracement line, double resistance lines from December 2008 and October 2010, and support line from December 2013

The validity of the head-and-shoulder pattern will be confirmed by price breaking the support line moving lower or simply residing below the support line, which at this point is very likely because of the speculative and institutional money flows that have been deteriorating since right about the formation of the left shoulder, leaving us with a conclusion that there is very low probability of bonds going higher any time soon, high probability of going lower, and confirming the business cycle patterns where bonds have started the bear market in stage 4 of the business cycle, ongoing bear market in current stage 5 of the business cycle, and most likely will continue the bear market in the final stage 6 of the business cycle.

Chart#1 (IEF) - Courtesy of TD Ameritrade ThinkorSwim

Stocks - SPDR S&P 500 Trust ETF (SPY)

The stock market has reached an overbought level where the recent sell-off has abruptly demolished the long-term momentum and the low volatility environment. From the charting point of view, it is becoming clear that stocks are also developing the head-and-shoulders pattern - but unlike bonds where this pattern is in the final stages and a bit slanted, stocks are at a middle of the head-and-shoulder pattern development, where the start of consolidation in January 2018 is the left shoulder, the recent October 2018 peak is the head top and about 12 months (=/- 3 months) before the head-and-shoulder pattern fully develops.

Should this pattern develop in a predicted time frame, the head-and-shoulder support line will be confirmed at around 250, which just like bonds is particularly strong and significant because this support line also happens to be a very strong 38% Fibonacci retracement line and double lows from February 2018 and April 2018 lows.

The validity of the head-and-shoulder pattern will be confirmed by price breaking the 250 support line moving lower or simply residing below the support line, which at this point is very likely because of the speculative and institutional money flows that have been deteriorating since the formation of the left shoulder, leaving us with a conclusion that there is low probability of stocks going higher any time soon, moderate probability of going lower, and confirming the business cycle patterns where stocks have started the bear market in the current stage 5 of the business cycle and most likely will continue the bear market in the final stage 6 of the business cycle.

Chart#2 (SPY) - Courtesy of TD Ameritrade ThinkorSwim

Commodities - Invesco DB Commodity Index Tracking ETF (DBC)

Looking at a long-term cycle, commodities are more in a rebound from a steep and long bear market rather than a classical bull market. Similar but not as convincing as bonds and stocks, commodities money flows' momentum are flattening if not deteriorating, where the main catalyst and tipping point will be apparently crude oil.

Overall, from the mid-term business cycle perspective this is a credible bull market condition, and confirming the business cycle patterns where commodities are in an ongoing bull market in the current stage 5 of the business cycle and most likely will reverse and start the bear market in the final stage 6 of the business cycle.

Chart#3 (DBC) - Courtesy of TD Ameritrade ThinkorSwim

Sector Rotation Analysis

Following up on the Business Cycle and breaking down the stocks by sector, key pointers is that the energy sector leadership outperformance is a confirmation of a market top, while expected change of leadership and outperformance by consumer staples and more so healthcare sectors is going to be a confirmation point of beginning of a stock bear market.

Sector Rotation Map - Courtesy of Stock Charts (StockCharts.com | Simply The Web's Best Financial Charts)

When we take a closer look at the technical, money flow and comparative analysis for stock sectors, we see that that it does not stack up closely with the sector rotation chart above, with the exception of the healthcare sector (excluding biotechnology industry) that is on path to be the most dominant outperformer for some time - given the acceleration momentum and long-term money-flows.

Chart#4 (XLV) - Courtesy of TD Ameritrade ThinkorSwim

We will also look at the two other spreads that are a good gauge of stock market tops: consumer staples - consumer cyclical stocks and value - growth stocks.

What stands out is that both spreads are have reached extreme oversold levels and reversing (RSI < 30 then > 30). Value - growth spread was last time at these levels in January 2019 while consumer staples - consumer cyclicals were never on these levels.

Chart#5 (XLP) - (XLY) - Courtesy of TD Ameritrade ThinkorSwim

Chart#6 (IWD) - (IWF) - Courtesy of TD Ameritrade ThinkorSwim

10-year/2-year yield spread overlay to the Business Cycle

There is no question and the debate is over whether the long yields have reached a bottom and that the 20-year bear market is over. The debate has shifted in good part to the question "is the 10-year/2-year yield spread a reliable recession indicator - should it continue to drift down and enter negative territory, or is this just a statistical coincidence?"

In our view and technically speaking it is not a statistical coincidence and more importantly from the behavioral finance point of view, it is already engraved in everybody's mind as a probable and significant recession indicators - so if the pattern plays out as it did many times before, you do not want to be a contrarian to this theory.

Chart#7 - 10-year/2-year yield spread - Courtesy of TD Ameritrade ThinkorSwim

So let's revisit the 10-year - 2-year spread chart above and see what the price patterns are signaling and how does that compare to the stock market and bond market directional and timing bias and business cycle in general.

10-year - 2-year yield spread is still on track to inversion due to strong long-term momentum and unbreached downtrend, while the spread is showing mixed short-term signals that altogether indicate that we are close to the bottom of the spread that will be most likely at inversion point soon.

Historically, the spread consolidation following an inversion lasted about 12 months and about 6 months later followed with a recession, which coincides exactly with the timing of the head-and-shoulder support line breach and beginning of a stock bear market - as I wrote above.

This time frame and spread chart analysis mentioned above also conforms with the Federal Reserve plan and timing of the interest rate hikes, which has two phases from here:

  1. Phase one/12 months reflected in the consolidation pattern of the spread - where the battle is who raises rates faster, the Fed short-term rates or the market long-term rates, and
  2. Phase two/6 months reflected in the reversal of the spread - where the Fed moderates or reverses the interest rate policy and followed by a recession.

Conclusion

Business cycles are a steady long-term factor that many investors and particularly trades often oversee, being more often than not overwhelmed by short-term factors and noise in the markets. If markets are waves resembling market moves, then the business cycle is the tide resembling the market shifts. The analogy comes from surfers (being one myself) who always and first check the tide while dry and before getting on the board.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.