Like economies, markets have cycles. These cycles phases usually help to define what sectors and asset classes are in and out of favor. In full cycle trading and investing what one is hoping to identify are potential winners that benefit from where we are in the economic cycle.
The thirst for alpha throughout the bull market
The philosophy behind full cycle trading and investing is capitalizing on economic phases to maximize returns and minimize risk. After all, many institutional investors tend to follow these phases with their portfolio weightings. With good reason, too, as what's in favor throughout a market cycle often has a lot to do with where risk and reward may be asymmetrically favoring opportunistic capital allocation. Of course, this can lead to extremes, too, which is one reason rotations can be so violent when capital is leaving one sector and entering another.
The phases of an economic cycle start with a repair, recovery, expansion, and finally a downturn. Each phase has different ramifications for the economy, corporations, and where money flows in to and out of from investors and traders.
How economic cycles typically begin
In the repair phase, typically we see more accommodative fiscal and/or monetary policy, and as a result we often have a reduction in funding costs, an increasing abundance of liquidity, and even programs that benefit specific industries and companies.
For example, during the COVID correction the Federal Reserve and other central banks around the world went to great lengths to unleash a veritable wall of liquidity throughout the global financial system. That monetary stimulus was coupled with many governments engaging in aggressive fiscal policies to try to stimulate economic activity and cushion from a hard landing.
The commensurate increase in money supply led to a strong bid for just about every imaginable asset, including stocks, real estate, bonds, commodities, as well as crypto. At least at first.
After the initial repair phase we entered an economic recovery
As the velocity of that central bank liquidity entering the system began to fade, so too did the appetite for more speculative assets. Especially within small to mid cap growth, tech, biotech, SPACs, and a number of Chinese names. It's no coincidence that the speculative peak in many of the aforementioned assets happened around Feb-May as that was when the velocity of central bank liquidity began to decelerate meaningfully.
The reason for this velocity falling off so quickly was that the majority of monetary policy was front-loaded rather than being increased over time. The prevailing thought being that there was no time to spare with the global economy being shuttered from lockdowns and quarantines. As a result this pulled forward, to some degree, the next part of this cycle which is called the "recovery" phase. Economic activity began to snap back, in part because of a combination of base effects, pent up demand, and an enormous amount of money added to both the financial system and the pocketbooks of families around the world.
As a result of increasing economic activity, we saw better econometrics and periodic upward pressure on yields and curve steepening and a financial media narrative change to "reflation." We also, especially lately, have seen real rates begin to meaningfully rise in no small part because of the Federal Reserve's posture change toward hawkishness.
The changes both in the nominal and real rates higher, as well as the velocity of these changes, has an impact on investor sentiment and rotational preferences. Thus all of these aforementioned factors are pushing us ever further in to the economic cycle and in to the expansion phase.
Capitalizing on what's in favor when it's in favor during the expansion phase
Assets that may not produce any cash for a long period (if ever) are less attractive in such an environment, and assets which do produce cash or are in higher demand (or both) tend to benefit.
For example, agricultural producers, energy companies, financials, industrials, materials, and other late cycle plays have been in higher demand. As have many of the underlying commodities that benefit some of these players. For financials, which deal with lending and the spread between the short and long end of the yield curve, they benefit from that widening spread to capitalize on lending operations.
Many commodities also often have cyclicality within their own individual demand, usually peaking toward the tail-end of the expansion phase of an economic cycle.
While no two cycles look exactly the same, if we monitor which sectors are in favor over weekly, monthly, and quarterly time frames we can identify where institutional funds are flowing. ETF inflows and outflows (available on ETF.com) for example can be helpful, as can watching charts and comparing price action and technical analysis. Which sectors and stocks are breaking out and which are breaking down?
Awareness of technical patterns is something I strongly suggest any inspiring investor and trader become aware of, such that one can glance at a chart and identify them quickly and reliably.
I typically look at the top three sectors and then identify the strongest setups from players within them both from a fundamental and technical basis. The convergence of fundamental (below 1 PEG for example) and technical signals (like break-outs above resistance, new 52-week highs) provides a more robust trade or investment thesis while also allowing us to have more than one guidepost for the validity of our thesis should circumstances change for better or worse.
The benefits of full cycle trading and investing
A data-driven approach helps to remove emotion and ego. After all, making having trades and investment that produce good returns over time is not about whether we are right or wrong, it's instead about not staying wrong for long and riding those winners as long as our thesis is valid.
Another element of this approach that I like is that these strategies can potentially apply to multiple time frames. Daily, weekly, monthly, and yearly changes in sector preference can potentially produce outsize returns when capitalizing on shifts in market sentiment.
The first week of January 2022 (shown above as a heat map of the S&P 500) was a great example as we saw a large shift out of tech and in to energy and financials, in part because of the Fed, energy prices, and re-pricing of risk in the bond and equity markets as a result.
When is it time to move on to the next opportunity?
While navigating these regime changes in sector allocation preference as trades or investments it's important to also become aware of when that sector may no longer be in favor. To identify the end of a sector being in favor it's important to look for rotational flows out of sectors (bottom performers), technical break downs, ETF net outflows, and changes within econometrics and other factors (such as commodities pricing, yield curve steepness, and related heuristics that can provide constructive feedback).
Stay tuned to learn more about full cycle trading and investing as this is a topic I plan to continue to write about as we navigate 2022, a year that we believe will afford many trading and investment opportunities.