A late-cycle investing guide

As expansion grows old, adjust your portfolio

Where are we in the business cycle? Late. Just how late? Very late. In baseball parlance, I would say the bottom of the eighth. This long economic expansion and bull market run is into year number nine, and really is long in the tooth.

This isn’t just because of the length of this cycle, which is the third-longest business expansion since the end of the Civil War.

No expansion dies from old age alone.

They typically end from a Fed tightening cycle which we are in.

They typically end because of acute capacity constraints, which have indeed appeared in several cases.

They end after a prolonged period of excesses, classic late-cycle developments, where euphoric behaviour coincides with extremely lax lending terms and covenants for borrowers.

Valuations on risk assets become very stretched, which of course we see in many large-cap growth stocks and in high-yield corporate bond spreads which have compressed to July 2007 lows (the same for the investment-grade bond market where net inflows have attracted $59 billion of new inflow from January to May, on track for the most hectic buying activity on record).

They end when bubble conditions come to the surface, and not just in the credit markets this time around but also in passive ETF investing (which took in a record $314 billion last year).

Remember Wall Street legend Bob Farrell’s Rule #5: “The public buys the most at the top and the least at the bottom.”

And these cycles generally end when the prior abundance of liquidity turns into a scarcity of liquidity, but by the time we see these conditions shift, it is typically too late. credit and cyclically sensitive activity relative to the overall economy. We found that the median of these 15 indicators are completely maxed out and the average shows we are nearly 90 per cent through this economic cycle.

In the context of the current length of this elongated expansion, this basically means the runway has another year left. This may in fact be quite generous, because when you look at the past, recessions start around three months after bond yields peak (which was late last year) and six months following the bottom of the unemployment rate.

There are few better indicators of how bellies are filled, with no more pent-up demand left in the tank, then when the consumer confidence indices hit their cycle highs … this is an absolutely phenomenal contrary indicator, and also is consistent with a recession occurring sometime in 2018.

But as you can see, almost every indicator, and I would have to believe that 15 is a large enough sample size, has run its course based on the average and median performance of post-WWII economic cycles.

Only one — the employment-to-population ratio — is still in early-cycle mode. But the problem is that the folks who left the labour force this cycle, for a whole range of reasons, some of which are demographic due to the retiree wave and some are structural as in a chronic skills mismatch, may have limited the effectiveness of this metric. But we did need a balance to the sliding U3 unemployment rate and a separate measure that goes back six decades.

And while we never did believe inflation was going to be anything but a brief spurt this cycle, there was a notable period of acceleration, as oil prices firmed and rental rates rose sharply — just as we had in the last cycle, when core inflation peaked below three per cent (this time around, below 2.5 per cent) and yet we still had a recession on our hands by early 2008.

So timing aside, 14 of the 15 indicators in the table included here are in a classic late-cycle pattern. The average performance of these measures strongly suggests we are about 90 per cent through the expansion and bull market. So how to invest? Answer: Be aware of where we are in the cycle and act appropriately by having an optimal portfolio for this part of the business cycle.

Raise some cash — sometimes a one-per-cent yield on a three-month T-bill will have to suffice.

Reduce domestic cyclical exposure.

Focus on companies with strong balance sheets; low refinancing risks.

Cut the overall beta of the equity portfolio.

Screen more heavily on earnings quality and predictability.

Protect the equity portfolio by writing call options or buying puts.

Diversify geographically into markets that are in an earlier part of the cycle (many parts of Europe, Asia).

Step up investments in dividend growth/yield and in less economically sensitive parts of the market.

Credit hedge funds with attention paid to better quality should help preserve capital and provide a recurring cash flow.

Long-term bond yields (even zero coupon) never rise during a recession so no matter how low they are, then can indeed go even lower unless this game goes to extra innings.