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Bollinger: A Cyclical Assessment

05/19/2006 12:00 am EST


John Bollinger

President and Founder, Bollinger Capital Management

Technical and fundamental expert John Bollinger has a remarkable ability to take even the most complex technical market issues and provide investors with a clear, concise, and understandable overview. Here, he looks at where we stand in the current market cycle.

"We are getting ever more nervous about the financial markets. A few of the reasons are gold soaring, crude at new highs, interest rates trending higher, strong commodities, strong cyclical stocks, etc. The interesting thing is that all of these factors seem like typical late-cycle market behavior and late cycle is not the time to own stocks; it is the time to be selling stocks.

"A milestone was seen recently in our proprietary GroupPower sector report a few weeks back. At the time we had the Energy, Basic Materials, and Industry sectors as the top three sectors. At the same time Yield was the bottom sector, accompanied by Health. We described this as typical late-cycle behavior and a forecast for continued economic strength. The core idea behind that description is that there is an economic cycle that repeats in roughly the same structure over time.

"I first learned of it as a relationship between stock prices, interest rates, and commodity (basic materials) prices. In an idealized depiction of this cycle, we start from the bottom of the cycle, and stock prices start up followed by a trough in interest rates. Then interest rates start rising too. Next commodity prices trough and turn higher.

"We are now in the main expansion phase of the cycle with all three elements trending higher. Next, rising interest rates start to worry stocks, which flatten out. Interest rates continue higher and stocks turn down in earnest as they begin to sense an economic slowdown. Demand for money starts to slacken and interest rates peak. We are now into the down portion of the cycle.

"Now interest rates turn down as the monetary authorities perceive weakness and commodity prices top out and start to weaken, leading to the heart of the down cycle. Interest rates are now falling and stocks are beginning to think about a recovery so their downside momentum wanes. Commodities are now exhibiting strong downside momentum and the trough of the cycle is looming.

"Next stocks start to sense the effects of lower interest rates, trough, and we see the first signs of strength. Interest rates continue down but the pace decelerates and stocks begin to rally seriously. Next interest rates begin to firm up followed by a turn up in commodity prices. At this stage of the game we are back to where we started and the cycle repeats.

"Of course this is an idealized cycle and we never see anything quite like it in real life. But the relationships and ideas do hold together and from those relationships we can often estimate where we are in the cycle and estimate how the future is likely to look. At present with stock prices, commodity prices, and interest rates all rising at the same time we can say that we are in the latter part of the cycle with decent confidence. That means that we ought to start worrying about a top in stocks and thinking about high interest rates, and so we are.

"One of the more interesting aspects of this process is that different groups of stocks tend to behave differently in different phases of the cycle. Defensive sectors such as health and consumer non-cyclicals tend to be late-cycle performers, while technology tends to be an early-cycle mover. There are other stock market facets to the puzzle that can be of interest as well. For example, value typically has an advantage later in the cycle while growth does better earlier on. Likewise, smaller stocks tend to do well earlier on and larger stocks later in the cycle.

"Repeated for emphasis: We have described the ideal cycle here and the real world is very messy by comparison. These cycles vary greatly in amplitude and periodicity and can even repeat, backtrack, and/or skip sections. Yet there is an edge here for those who want to think about such things. In our view the evidence is quite clear that we are late in the cycle and our mind is shifting to defense with our eyes focused on the door. We are happy to play for now, but we want to have a chair when the music stops.

"Small- and mid-sized stocks continue to lead. As usual the chorus is loud and adamant regarding the death of this trend and just as usual, there is no end in sight yet. Value is maintaining an edge for larger stocks while growth keeps on trying to establish a leadership role for smaller stocks.

"From our perspective Japan is still the most interesting international market. Now trying to break out after a period of consolidation, Japanese stocks are clearly trying to suggest an end to Japan's economic malaise. From our perspective this is a buy, the dips and hold for the expansion type market. The second market we think is important to be involved in is the Chinese market. Of course we regard this as more risky, but we also think it has greater potential.

"So, what does all this mean? I'd guess it might mean a buying opportunity for bonds in the making; maybe as early as mid-year, but most likely a year or more out. For now, avoid bonds, or, if you must invest in bonds, keep your maturities very short so you can reinvest at higher rates as opportunities present themselves. Indeed, low rates were amongst the motive forces in getting a rally in stocks going. In the not too far distant future it may be stocks that investors are turning their backs on to buy bonds.

"Gold is traded at a new highs and while we remain uncomfortable with the investment potential we are fully cognizant of the message that high transmitted, which is, in a word, inflation. Commodities in general echo the inflation message with energy's cry being particularly loud and now interest rates are starting to pay attention. Our message is simple--you should be paying attention too.

"As for oil, well, just when everyone thought it was safe again, that Katrina was behind us and that crude was headed back to $50, oil rallies to a shocking new high. (Yes, $50 now seems like a good price. How quickly we adjust!) While others point to factors such as Iran, Nigeria, and refining disruptions, I think most have missed the real problem--demand, demand, demand!

"The important points are not supply disruptions and refining factors, they are fleeting; it is demand, pure and simple. The world simply wants more oil than is being produced and the only thing that will address that problem is a reduction in demand caused by slowing in the world economy. One-off factors may have short turn impacts, but the tune is being called by a global expansion in population and economic development.

"As a global recession is not in the immediate cards, you can assume that oil prices will remain high and that a variety of excuses will continue to be trotted out to explain it. Eventually, reality of regime changes will assert itself, but we see no signs of that happening at present. Thus, oil prices will remain a problem for the foreseeable future. The bottom line is that oil stocks remain attractive and can be bought on pullbacks.

"As expected, our Commodity Composite has risen to a new high. Our composite is an equal-weighted index comprised of the CRB, Moodys, and Reuter's indices. It is very heavily biased toward industrial commodities and has relatively little energy exposure. In short it is a good, basic measure of commodity prices. We note that all three components recently made new highs and there is very little to suggest any end to the uptrend as of yet. The inflationary implications of this are being ignored for now, but they will become a topic of conversation before we are done with this cycle."

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