- Costco’s price pattern is closely related to the business cycle.
- Costco outperforms the market when business slows down.
- Costco will continue to outperform the market.
As discussed in my article of 12/15/2020 - Costco: A Great Defensive Play, The Issue Is Timing – Costco (NASDAQ:COST) has a distinct pattern closely tied to the business cycle.
Costco declined more than 19% from December 2020 to March 2021. It has underperformed the market from March 2020 to March 2021. Costco has been outperforming the market in a major way since April 2021.
The price action of Costco raises two questions. Is Costco likely to continue to outperform the market? If so, what is its price action telling us about the future of the economy?
This is what I wrote in April 2021 (here).
The sharp increase in inflation, interest rates, and commodities we have been experiencing suggests we are close to the Phase 2-Phase 3 turning point of the business cycle.
The ratio COST/SPY has reached oversold conditions, coinciding in the past with a peak of the business cycle. These oversold conditions suggest Costco will continue to outperform the market (emphasis added).
The strength of Costco compared to the market may suggest investors are beginning to position their portfolios for the Phase 2-Phase 3 turning point of the business cycle.
Costco did indeed outperform the market. The issue now is whether it will continue to do so.
The price pattern of Costco compared to the S&P 500 is particularly telling because it might give further information on the position of the business cycle.
The above chart shows two panels. The graphs in the above panel represent the ratio between COST and SPY. The second graph is its 200-day moving average. The graphs rise when COST out-performs SPY. The graphs decline when COST under-performs SPY. Investors are going to outperform the market if they invest in COST when the graphs rise.
The bottom panel shows the spread between the ratio COST/SPY and its 200-day moving average. The resulting pattern is unique and quite telling.
The first feature is the spread reached oversold conditions in April 2021. Since then, Costco outperformed the market until recently as reflected by the rising ratio COST/SPY shown in the top panel of the chart. The same pattern took place in 2007. 2009. 2014, and 2017.
The importance of knowing where we are in the business cycle has also major implications on the continued outperformance of Costco and the selection of stocks to be in a portfolio.
The performance of stocks like Costco relative to the stock market depends on the position of the business cycle.
There are two crucial turning points of the business cycle. The first one is when business transitions from Phase 2 to Phase 3. The second point is when the business cycle moves from Phase 4 to Phase 1 (see above chart). Both points signal important changes in price performance of the major market sectors as discussed in detail here.
In Phase 2 of the business cycle, the business is facing strong demand and needs to replenish inventories to meet sales. The increased production is achieved by buying more raw materials, hiring more people, and increasing borrowing to expand and improve productive capacity.
The outcome of these decisions is higher commodity prices, rising wages, and higher interest rates. The combination of these factors is transmitted to the consumer as higher inflation. Personal income after inflation, and disposable personal income after inflation and after-tax decline. This crucial situation is reflected in sharply lower consumer sentiment. This is the current position of the business cycle.
The consumers’ decline in spending power is reflected in slower growth in demand, resulting in unwanted inventory accumulation. Business finally recognizes the economic landscape has changed and inventories need to be cut by reducing production. This is the next development of the business cycle.
The implication is buying raw materials is curtailed, the workweek is cut, and borrowing must also be reduced. These decisions will cause lower commodity prices, slower growth in wages, and lower interest rates. This is the time the business cycle transitions into Phase 3 and eventually to Phase 4, reflecting seriously deteriorating business activity.
Another intriguing feature of Costco is that it is closely related to the business cycle as shown by the above graph. The spread between COST/SPY and its 200-day moving average is shown in the upper panel.
The lower panel shows Peter Dag’s Business Cycle Indicator which is updated in each issue of The Peter Dag Portfolio Strategy and Management.
The interesting feature of the chart is the bottom of the spread coincides with a peak of the business cycle. In other words, the peak of the spread takes place when the business cycle bottoms.
For instance, the spread bottomed in 2018 (see first chart), reflecting an oversold condition for Costco. This is the time when the stock started to outperform the market for about two years. The year 2018 was also the time when our Business Cycle Indicator peaked, reflecting a period of slower economic growth until 2020.
In the first quarter of 2021, the spread did again reach extreme oversold conditions. This was also the time when our Business Cycle Indicator peaked. The price of Costco rebounded strongly, outperforming the SPY since then.
- The transition of the business cycle from Phase 2 to Phase 3 signals the need to rebalance the investment portfolio into defensive sectors.
- The sharp increase in inflation, interest rates, and commodities suggests the business cycle is facing a prolonged period of slower growth as reflected by our Business Cycle Indicator and due to the decline in consumers’ spending power after inflation and after tax.
- COST will continue to outperform SPY as the economy slows down.
- The time to reduce exposure to Costco is when the business cycle rises, responding to much lower inflation and employments costs. At that time consumer spending power after inflation increases and cyclical stocks become more attractive than Costco.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of COST either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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