People often describe markets in terms of being in an “up-cycle” or “down-cycle,” without justifying that conclusion. 

I like to use leading economic indicators – LEIs – to objectively determine our location in an economic cycle, with a precise quantitative metric.

“Leading economic indicators are those that change before economies show any signs of change.” LEIs are a single number, broadly based on four inputs:

1. Labor Market: The amount of slack in labor.

2. Consumption: The robustness of the local consumer spending activities.

3. Production: The amount of slack in manufacturing.

4. Market Prices: The stock market is believed to be a forward-looking market. In addition to stock market performance, the market level of interest rates and the shape of the interest rate curve are used in LEI calculations.

I think LEIs are good way to track the global cycle. Below is a chart of one of the U.S. LEIs (Each country tends to have multiple leading indicators.) As you can see, the year-over-year metric makes it easy to separate expansion cycles from deceleration cycles (upward sloping vs. downward sloping).

US ECONOMIC CYCLE INDICATOR

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US ECONOMIC CYCLE INDICATOR

Moreover, you can go one additional step and segment episodes of deceleration from contraction, by when the indicator falls below zero. Notice the so-called energy recession in 2015; it was a slowdown/deceleration, but not a contraction. The COVID-19 slowdown in 2020, on the other hand, was a contraction.

Yearly changes in LEIs, like those shown, tend to be very slow-moving indicators. They are cyclical indicators, not tactical indicators. I like to think of a major economy, like the U.S., as a tanker ship. It takes a long time, months, for the tanker to change direction (it’s a tanker, not a jet-ski), but when it does change course, it tends to continue in that new direction for multiple years at a time.

Knowing whether you are in an economic “up-cycle” or “down-cycle” can be used to adjust your investment risk profile. It is prudent, but not a guaranteed formula for success, to move “up higher on the capitalization structure” during down cycles. What does that mean? During down cycles:

• Developed market equities tend to outperform emerging markets;

• Firms with higher quality balance sheets tend to outperform;

• You want to be long the liquidity risk premium, not short;

• You want to build natural hedges (e.g., being long fixed income duration and convexity); etc., etc., etc.

In short, it is prudent to reduce your portfolio risk profile during “down” markets.