The economic cycle seems to be transitioning from phase 2, in which GDP and inflation accelerate, to phase 3, in which GDP decelerates and inflation continues to move higher. If our quantitative assessment is correct, the long exposure of portfolios (read: risk) should be taken down a notch. This is exactly what we’ve been doing: cutting some small losses to prevent them from becoming big losses and taking some profits to raise cash to protect the value of our portfolios and have some dry powder for the next pullback or correction. 

The Main Trend of the USD was down not too long ago, favoring the bull market in equities. It is now neutral. From neutral it may go back to bearish (down) or transition to bullish (up). This is important because in the last phase of the economic cycle, phase 4, financial markets collapse and the USD regains value and strength together with the price of US Treasuries. We are not saying that this is the beginning of a bear market, but it would be naïve to neglect the short term strength of the USD and Treasuries. Also, it is worth noting the rotation of capital out of the reflation trade and into defensive sectors and large cap growth, such as technology. This type of behavior is typical of phase 3. The dilemma is to figure out whether the economy is pivoting from phase 2 into phase 3 or into phase 4. The outcome between phase 3 and phase 4 should be very different for investors. 

Regardless of strong earnings in financials, which is part of the reflation trade, money has been rotating out of banks, out of consumer discretionary and to certain extent, out of industrials and transportation, too. If you look at our Greenwich Creek Capital quantitative Market Trend (*) table here, you’ll see the USD highlighted in red. You’ll also see technology (XLK), consumer staples (XLP) and utilities (XLU) all highlighted in red. Defensive sectors (XLP / XLU) and technology tend to do very well in phase 3 of the economic cycle. Check the table: all three sectors look very healthy compared to others. 

The USD and Treasuries perform very well in phase 4. U.S. Treasuries move up in price (yield down) during phase 4. It is not a coincidence that all three trends of the 10 Year US Treasury Yield (highlighted in red on the table) are under downward pressure. Note that as yield moves down, price moves up and vice versa. This relationship between price and yield never changes. Check the table: all three USD trends are bullish and all three 10 Year Treasury Yield are bearish (price up) indicating an economic slowdown (flattening of the yield curve). Note that the Main Trends (far right column) of the USD and Treasuries remain up, but if short term downward pressure continues, the Main Trend may change from bullish to bearish. 

Take a look at all the Main Trends on the table, from top to bottom: currently they are aligned for the bull market to continue longer term. The Main Trends of all US stock market indices are bullish, while volatility (VIX) is bearish and 10 Year Treasury Yield is bullish indicating a strengthening economy longer term. So far, perfect harmony for a secular bull market. The problem is to get from bearish short and midterm trends to the really long term bullishness of the current data. This transitioning period is the most difficult to execute because the bullishness of the Main Trends may change into bearish. 

Short term, the stock market is under pressure and the rotation of capital shows that, underneath the surface, investors are being more cautious while allocating capital to risk. Long term, we remain bullish and optimistic about the US stock market for now. China, some European markets, copper and transportation are signaling that a transition from bullish to bearish may be in the makes.     

Side note: Regardless of long term bullish trends in the US stock market, seasonality kicks in soon and selloffs and corrections are always possible. On average, during the last 50 years, August and September are the worst months of the year in terms of performance. If this year is no exception, expect volatility ahead.

(*) The Greenwich Creek Capital Market Trend table is not meant to be used in isolation, it is part of a more complex set of variables and it is not designed to provide trade entry and exit points.

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Saul A. Padilla, RIA

Saul A. Padilla, RIA

Registered Investment Adviser and founder of Greenwich Creek Capital Management LLC, bringing over 37 years of experience in managing discretionary and non-discretionary investment portfolios for wealthy families and institutions. His main focus is to protect invested capital by re-balancing the allocation of cash, equities, fixed income and commodities, while closely monitoring macro-economic indicators and market trends to determine the transition phase between the completion of a Bull Market and the beginning of a Bear Market. He started his career in early 1987 mainly managing family financial investments.