Pring Turner Approach to Business Cycle

Investing
May 3, 2013
by Team
of AdvisorShares
Introduction

The investment strategies utilized by Pring Turner Capital Group at one extreme draws on our
assessment of very long-term secular trends in bonds, stocks and commodities; at the other, our
stringent risk control strategies. The heart of our investment approach though, focusses on business
cycle associated trends for bonds, stocks and commodities and is based on two observations. First, the
typical four to five year business cycle consists of a series of chronological events that have continually
repeated since the beginning of the industrial revolution over 150 years ago. Second, the optimal asset
allocation and sector rotation for investment portfolios can be adjusted based on the stage of the
business cycle in an effort to increase returns while reducing risks. The calendar year rotates through
four repeatable seasons, the knowledge of which empowers farmers to plant in the spring, harvest in
the fall and avoid the problematic cold of winter. Like the seasons of the year, the environment for
bonds, stocks, and commodities also changes in a repeatable and sequential fashion. Many investors
are unaware of and unprepared for the ever-changing financial market seasons.

What is the business cycle?

Reasonably reliable economic statistics in the U.S. go back to the start of the nineteenth century. Since
that time the U.S has observed consistent fluctuations in the level of economic activity between growth
and contraction, better known as the business cycle. According to the National Bureau of Economic
Research, since 1857 these cycles have averaged 56-months from trough to trough. It would be
convenient if the cycle operated on a regular beat and repeated more or less exactly on each occasion,
but unfortunately each cycle has its own unique characteristics. Thats because the economy consists
of many parts or sectors whose growth paths change from cycle to cycle. For example, in the opening
years of the twenty first century housing starts registered monthly annualized levels in excess of 2
million but after the housing bust the post 2009 recovery barely managed to reach 800,000 after three
years of progress. Whatever the reason we usually find there is typically one sector of the economy
that over-invests, over-builds or over-lends, which causes an increase of its share of the economic pie
on the way up and exaggerate the speed of its declining share on the way down.

Another reason for changing business cycle characteristics comes from substantial structural

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differences that take place over time. The source of such transformations might emanate from
demographic make-up, innovation, social trends and so forth. For example, in the early 1800s the U.S.
economy was strongly represented by farmers. Later manufacturing dominated and in the latter part of
the twentieth century the service industries came to the fore. The expanding role and influence of
federal, state and local governments is another factor. Innovation has meant that principal forms of
communication have moved from letters and telephones in the late twentieth century to the internet,
email, texting and mobile phones in the second decade of the twenty first and this is just the tip of the
iceberg. The one thing that does not change is the fact that the business cycle follows a
consistent, rational, and logical sequence of events, which continually provides new
investment opportunities.

Why does the business cycle repeat?

The alternation between recovery and recession is a direct function of people responding to positive
stimuli (the economic recovery) and subsequently repeating the same mistakes that cause a
contraction. These decisions are psychologically driven, either in anticipation of future conditions, or as
a response to existing ones. For example, corporations expand their capacity to produce because they
anticipate future growth. On the other hand, workers are often laid off in response to declining sales.
The essential point to grasp is the business cycle develops because human nature is more or less
constant. They say that history repeats but never exactly. The same is true of the business cycle.
People make the same mistakes, but each time it is different people in different sectors making
mistakes. Put yourself in the same position as a business owner and you will understand why it is so
easy to make the same mistakes. If business activity has been contracting and your company is really
suffering along with your competitors it is easier to make those cost cutting decisions. On the other
hand, if you are certain that the economy is going to pick up next month you would perhaps postpone
or cancel the cost cutting exercise. The regularity is in the pattern of these reactions, not in the cycle
itself is how the late Dr. Richard Coghlan put it in his book (McGraw Hill, London, 1992).

Demonstrating the business cycle sequence

When most people think of the relationship between the stock market and the economy it most likely
resembles a tangled web of confusion as shown in Chart 1.

Chart 1: The Random Noise of Economic News

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(Economic Data Source: Economic Cycle Research Institute)

Business Activity is never smooth, and investors are continually bombarded with economic noise.
How can an investor make sense of this tangled economic Gordian knot?

In reality, there is order to the system and the cycle is continually progressing through a set sequence
of events or turning points. Chart 2 attempts to bring order to the chaos featured Chart 1 by separating
the three indicators and arranging them in their chronological sequence. Each has been plotted in
momentum format in order to emphasize its cyclic rhythm.

Chart 2: Real World Business Cycle Sequence

(Economic Data Source: Economic Cycle Research Institute)

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Separating the momentum of economic indicators and placing them in sequence brings clarity to the
random noise. Business cycle turning points are readily identified, giving investors an important
edge.

The names Leading, Coincident and Lagging are derived from the fact that these series are
constructed from several economic indicators that lead the economy, coincide with the economy and
lag the economy. An example of a leading indicator might be the highly interest sensitive housing
market. Nonfarm payrolls, industrial production and Gross Domestic Product (GDP) are examples of
coincident indicators. Capital spending tends to increase when factories are humming in the late
stages of the cycle and would, alongside the unemployment numbers represent lagging aspects of the
economy. Chart 2 clearly demonstrates these indicators live up to expectations as peaks in the leading
series form ahead of the coincident indicators, which in turn lead the lagging series. The difference in
each cycle lies in the leads and lags as well as magnitude. Cyclical troughs also experience the same
chronology.

How do market turning points fit into the cycle?

The lead, coincident and lag sequence is of course a gross over simplification since there are literally
hundreds of such turning points for each facet of the economy in any given cycle. The practical
benefit of this knowledge is that the turning points of bonds, stocks and commodities are all
part of the business cycle sequence. These are shown in Figure 1 together with a theoretical
growth path of the economy. In this instance the trajectory is assumed to be that of a coincident
indicator such as GDP. Lets briefly consider how the financial markets fit into the sequence starting
with the onset of a recession.

Figure 1: Theoretical Business Cycle Sequence

(Source: Pring Turner Capital Group)

The simple bell-shaped curve illustrates continuous change in the economy with one cycle leading

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into the next. Investors can benefit by observing the normal, sequential, and repetitive nature of the
economy.

As Interest rates peak: Own bonds

Most people think that interest rates peak as the economy enters a recession, however the peak
typically develops after the recession has already begun. Interest rates are the price of credit and move
inversely with bond prices. Like any other item, interest rates are determined by the interaction of
supply/demand pressures.

The biggest player on the supply side is the Federal Reserve through its influence on the banking
system. One reason why the Fed acts with a lag is because the central bank has to make sure that
policy changes are backed up by a solid trend of emerging statistics, which can take some time to
develop. When the economy is in full blown growth mode, the Fed is concerned with restraining
inflation. However as the economy moves into a recession the Fed comes to the realization that
unemployment and not inflation is their main concern and therefore injects liquidity into the system. In
the meantime the weakening economy reduces the demand side of the credit picture. Declining
demand and increasing supply leads to lower interest rates. As interest rates drop, bond prices rally.

Maximum Economic Pessimism: Stocks Bottom Out

As interest rates peak the seeds are being sewn for the next economic recovery. The stock market is a
leading indicator and does not wait for good economic news but instead discounts it ahead of time. In
the depths of recession and after interest rates have declined and bond prices appreciated, the stock
market begins to turn up. This befuddles most investors because the stock market begins a dynamic
cyclical advance when the economic news cannot be any worse. A stock market bottom by definition is
the point of maximum pessimism. Knowledgeable investors take advantage of the stock markets
character to be one of the most dependable leading indicators. It still takes courage (and cash) to buy
stock in the midst of miserable economic headlines. At this point in the business cycle two asset
classes are in cyclical bull market, bonds and stocks, while commodities are still underperforming.

Economic Growth Leads to Higher Commodity Prices

Typically commodity prices continue their bear market until after the economic recovery gets underway.
As the economy picks up steam, the demand for raw materials increases. Usually commodity prices do
not experience a sustained rally until fundamental demand from real users as opposed to speculators
sets in, and this can only happen when the economy has emerged from the recession. At this point in
the business cycle all three asset classes are in cyclical bull markets. This is distinctive of this part of
the business cycle where all three asset classes are doing well, and everyone is an investment genius.

Interest Rates Bottom and Bond Prices Peak

At this point in the cycle all three markets are in a rising trend, but like all good parties, this one too
must come to an end. As signs of a more robust economy appear there is no longer any pressure on
the Fed to continue with an easy money policy so they start to turn off the monetary printing presses.

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The policy does not immediately turn into a tight one, just less accommodative. This shift, along with an
increasing demand for loans as consumers and businesses are willing to take on more debt, has the
effect of pushing up interest rates, which leads to falling bond prices. Provided profits can rise at a
faster rate than interest rates the stock market is able to extend its rally. Not all equity sectors
participate though, because rising rates usually have an adverse effect on interest sensitive stocks.
Additionally, bond equivalents, such as preferred shares, have to compete with bonds themselves. This
means that their yields must rise to meet that competition, and prices must fall accordingly. As a result,
while the overall market as reflected in the S&P Composite might extend its bull market, breadth begins
to narrow as fewer stocks are now participating in the bull market.

Anticipating the Next Recession: Stocks Peak

Eventually stock market participants sense the trend of rising rates has progressed to the point that a
slowdown or actual recession will result. Like anyone standing on a railroad track and knowing a train
is coming, stock holders do the logical thing and get off the track right away. Not all stocks move lower
as those benefiting from higher commodity prices, such as basic industry, mining and energy
experience wider profit margins and usually manage to extend their gains at this point.

The Slowing Economy Push Commodities Lower

Eventually though, strains on the system begin to emerge. The trend of sharply rising commodity
prices encourages the Fed to be far more aggressive in its monetary policy, and the Fed begins to
tighten. This renewed push on higher rates breaks the back of those sectors of the economy that are
still expanding, including the commodity area. Sagging demand for resources resulting from the
slowing economy pushes commodities into their cyclical downturn. Commodities peak out, either at the
very end of the recovery, or occasionally in the opening moments of the recession. Now all three asset
classes (bonds, stocks, and commodities) are declining. The business cycle is complete, and the next
step is to anticipate the move to the beginning of the cycle for a repeat of the process.

The Double Cycle

Occasionally the growth path of the economy does not experience an actual contraction but instead
bottoms out close to the equilibrium point (0% GDP growth). This phenomenon is known as a growth
recession because it is only a recession in terms of the growth curve. We call this a double cycle
because the rotational bond, stock commodity process develops twice. Growth recessions develop
when the recovery is not particularly robust and few distortions are therefore created. This means the
self-correcting mechanism of the business cycle has less work to do, so the decline in the growth path
is therefore a mild one. Subsequently, the economy gets a second wind and in this second part of the
recovery the economy experiences distortions because capacity utilization levels are improving from a
higher level. Generally speaking the longer an economy goes without a negative correction the greater
the degree of confidence that builds up. There is, of course, nothing wrong with confidence. The
problem develops when people become overly confident, because thats when careless decisions are
made. The real estate developer who builds far too many houses, the banker that lends the developer
the money to build the homes. The buyer who purchases a bigger house because he extrapolates his
recent commission earnings trends in an everlasting linear uptrend and so forth.

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Introducing the Six Stages

Like the seasons of the year, the environment for bonds, stocks, and commodities also progress in a
repeatable and sequential fashion. Many investors are unaware of and unprepared for the ever-
changing financial market seasons. Anyone with gardening experience understands it is difficult to
plant in the winter because nothing grows. The same is true for the financial seasons in the business
cycle, where investors can use knowledge of the chronological bond, stock, and commodity sequence
to create a financial market roadmap. By better understanding these financial seasons and using the
correct forecasting tools, investors can make well-informed decisions and dramatically improve their
chances for investment success. Each asset class has two turning points in a given business cyclea
top and a bottom. This means that a typical cycle has a total of six juncturesthree buys and three
sells. We call these the Six Stages.

Figure 2: Pring Turners Six Stage Business Cycle Stages

The six-stage model can help investors dynamically adjust asset allocations around the typical
business cycle sequence. Essentially an investor needs two game plans one for defense to protect
assets in difficult periods and one for offense to grow wealth during favorable conditions.

The stages are illustrated in Figure 2 and begin with bonds in a bottoming mode and continue all the
way through until the eventual peak in commodity prices. The implication from the diagram is that each
stage is equal in duration, but in reality this is not the case. Occasionally two markets may reverse
simultaneously. This is what happened in October 1966 when both bonds and stocks bottomed
together. In such a situation the cycle moves from Stage 6, when all three markets are declining,
directly to Stage 2, where bonds and stocks are bullish and commodities bearish. Stage 1, in which
bonds are bullish and the other two markets are bearish, is therefore bypassed. The sequential
approach described here is by no means automatic. If it worked like clockwork in every cycle, everyone

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would be using this approach and it would be instantly discounted. Our research indicates that the six
stages move sequentially approximately 85 percent of the time, which offers an edge for investors.

How do we know which stage we are in?

The stages are identified through models or barometers for each of the three asset classes. They are
constructed from technical, economic and inter-market relationships that have been researched back
to 1955. Charts 3 thru 5 demonstrate their performance. The status of each barometer is used to
identify the prevailing stage of the cycle. Stage I occurs when bonds are positive and
stocks/commodities are negative. Stage II occurs when bonds and stocks are positive while
commodities remain negative; as so on and so forth. At Pring Turner we use this stage information to
establish the basic tactical asset allocations guidelines for our investment portfolios.

The green and red bands in the bottom of Figure 2 show when each asset class is positive (green) or
negative (red). For example bonds are positive in stages 1 thru 3, stocks in stages 2 thru 4 and
commodities stages 3 thru 5.

Chart 3: Pring Turner Bond Barometer 1956-2012

Chart 4: Pring Turner Stock Barometer 1956-2012

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Chart 5: Pring Turner Inflation Barometer 1956-2012

The barometers define favorable or unfavorable environments for bonds, stocks, and commodities,
when combined together the barometers define the business cycle stage.

Applying business-cycle stage shifts to tactical asset allocation changes

The key point in applying stage shifts to changes in tactical asset allocation is viewing asset allocation

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within the context of understanding the risk and reward characteristics of the different asset classes at
each stage of the economic cycle.

Table 1: Broad Business Cycle Asset Allocation Guidelines

This broad asset allocation guideline can serve as an important starting point for actively managing
portfolios throughout the business cycle.

For instance, during a recession in Stage 1 the allocation includes a healthy mix of bonds and cash to
stabilize portfolio values. The opposite is true in Stage 3, when the economy is running at full throttle
and maximum exposure to stocks is recommended. We believe that our six-stage framework is an
ideal way to construct an active allocation discipline, especially because it also serves as a critical risk-
management tool. Keep in mind that no strategy or discipline is perfect and that each has its own
shortcomings. In the case of economic fluctuations, not all cycles will experience every stage, and
stages occasionally diverge from the expected sequential order. Sometimes the cycle will skip a stage
or even two. In fact a cycle may also retrograde to a previous phase. These are additional reasons why
changes to portfolio allocations should be gradual. Larger allocation switches can be justified
only when the evidence of a change in the environment is overwhelming and markets have not already
gone too far in factoring this into prices. For investors, the beauty of following the repetitious
nature of the business cycle is an investment methodology that never goes out of style, an
all season approach if you will.

Does this business cycle stuff really work?

It is certainly a reasonable question to ask whether this approach has actually worked in the real world.
In 2012 S&P Dow Jones Indexes in conjunction with Pring Research launched the Dow Jones Pring
Business Cycle Index. The Index itself incorporates a rules based system to identify the six stages and
optimizes asset allocation in conjunction with sector rotation according to how each asset class and
sector has traditionally performed in that phase of the cycle. The performance of the Index by stage is
shown in Table 2. The two starting dates differ because the ETF instruments or tracking indexes used
in the Index were not available prior to 1994 so proxies were used between 1955-1994.

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Table 2: Dow Jones Pring Business Cycle Index Performance by Stage 1955-2011 and 1994-
2011

(Source: Dow Jones Indexes)

The combination of tactical asset allocation changes and effective sector rotation throughout the
business cycle resulted in positive returns in every stage (on average) and impressive risk-adjusted
returns. Note: Some individual stages experienced negative returns and future results will vary.

What the Dow Jones Pring Index illustrates is the combination of tactical asset allocation changes and
effective sector rotation throughout the business cycle resulted in positive returns in every stage (on
average) and strong risk adjusted returns during the 1956-2011 & 1994-2011 timeframes. Not every
stage in every cycle experienced positive returns but over the long-term the real world approach
supports the theory.

Dow Jones Indexes put together a nice performance illustration (Chart 6) which compares the
performance of the Dow Jones Pring Index with the three main asset classes over the 1956-2011
investment horizon.

Chart 6: Dow Jones Pring Business Cycle Index Performance 1955-2011

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Since 1956, the Dow Jones Pring U.S. Business Cycle Index has outperformed all three asset
classes while experience roughly two-thirds the risk (volatility) of the U.S. stock market. (Source: S&P
Dow Jones Indexes).

The table within chart 6 compares the return performance of the Index with the three asset classes in
addition to a comparison of risk using (standard deviation, volatility) calculations. It shows that not only
did the Index outperform the S&P but did so with lower risk (standard deviation, volatility).

Summary

1. Markets have tracked business cycle sequences for over 150 years since the
industrialization of the U.S. economy.
2. Financial markets are linked rationally, logically, and sequentially to the business cycle
which are driven primarily by human psychology.
3. Paying attention to the normal swings in the economy is an enormous help to investors.
4. Pring Turner organizes the business cycle into six stages to identify which asset class and
sectors to favor or underweight in each stage.
5. The stages are identified with the use of Pring Turners proprietary barometers for bonds,
stocks, and commodities.
6. Optimal asset allocation and sector rotation for portfolios can be adjusted based on the
business cycle stage in an effort to increase returns while reducing risks.

AdvisorShares

http://www.advisorshares.com/

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