Warren Buffett is perhaps the most famous and most successful investor alive. One quote that always stuck with me is especially prescient at this point in the economic cycle. “Only when the tide goes out do you discover who’s been swimming naked.”
Many investors will buy a stock and HOPE it goes up. Hope is not a strategy. A better way to manage risk and increase your odds of a better outcome is to use know where you are in the economic cycle. When using this approach, you see the bigger picture and not get so caught up in the day-to-day noise of the news and short-term swings in the markets.
First, we will define each stage of the cycle defined by the letters H.O.P.E. Each letter stands for a word that describes a phase of the economic cycle when entering a downturn. Conversely, it also works in reverse when the economy recovers. Paying close attention to the economic data assigned to each phase of the cycle can reveal big clues as to when markets will start to rise and fall as investors process the data according to each stage of the cycle.
H stands for Housing. The housing market is a leading indicator of the cycle and is the most sensitive to rising interest rates and tightening financial conditions. Recently you may have noticed that houses are not selling as fast as they used to be. Prices and mortgage rates have increased dramatically. According to Forbes magazine, the cost of a $400,000 mortgage rose from $1,708 per month in June 2021 to $2,471 per month in June 2022. If you consider the average price increase of 20% in that year, to monthly cost jumps to $2,965 per month. It’s no wonder the housing market is hitting the brakes. Affordability is a huge factor. Housing is usually the first to get hit at the start of recessions and first to recover when rates fall again.
Housing is the engine that drives the economy in many ways. When homebuilders can’t sell homes, they stop buying a lot of things. A ton of material and labor is involved in building a house. It affects many parts of the economy from lumber and materials, appliances, concrete, windows, real estate agents, mortgage brokers, the list goes on and on.
That leads us to the next letter on our list. O stands for Orders.
Orders for new goods are another leading indicator after housing activity starts to wane. If you are not getting new sales, who needs to order more stuff? Confidence in future business starts to fall. Businesses start to notice that they have way too much inventory on hand and thus cut back on new orders. Large retailers such as Wal-Mart and Target ordered way too much stuff during the pandemic largely because of supply chain issues to due to Covid, but now are stuck with warehouses overflowing with goods. Retailers are struggling. Prices will soon start to drop (a good thing for shoppers) but bad for business as profits will suffer. Which leads us to our next letter.
P stands for Profits. They say that profits and earnings are the “mother’s milk” of rising stock prices. An endless army of analysts on Wall Street do nothing all day but try to forecast future earnings for companies. But even analysts get surprised when companies issue their earnings reports that fail to meet analysts’ forecasts for sales and profits. When earnings surprise on the downside as they often do during recessions, stock prices tend to drop to meet the new reality.
E stands for Employment. Nobody really cares about the economy too much until it affects them directly. The most painful part of a downturn is the employment phase. The saying goes that it’s only a recession until you lose your job, then it’s a depression. In this phase, nothing seems to be going right. Housing is depressed, people are not buying as they were previous months, profits are down. Or worse yet, losses are creeping in. At this point, businesses have no choice but to cut costs. That means firing workers. You might be wondering, “how do things ever get better if businesses are firing workers and everything seems to spiral downwards?”
Well, there’s a silver lining here because when the economy suffers and the stock market is depressed and unemployment is high, interest rates start coming down again. When interest rates fall, money becomes cheaper to borrow. Mortgage rates come down and entice buyers that were priced out to the market previously, but now qualify for the house they wanted. And suddenly the cycle begins anew again.
Historically speaking, the down cycle can take up to four YEARS to run its course.
Where are we now? Every cycle is different. This cycle is more unique since we are faced with a double whammy of high inflation and slowing growth.
H. Housing has already started to enter a downturn.
O. Orders. According to the latest indicators, orders for new goods are starting to fall compared to a year ago.
P. Profits. Profit forecasts have declined since the beginning of the year. But not by much. Forecasted profits for 2023 have not yet been cut significantly.
E. Employment. A mixed picture. The economy is still adding jobs with wages increasing and labor in relatively short supply. But there are clouds forming on the horizon. Reports of hiring freezes and outright job cuts are starting to appear.
Bottom line? I’d say we are about in the 3rd or 4th inning of the ball game. The latter stages of the downturn can cause the stock market to fall even more precipitously. The tide has not fully gone out yet. Don’t be the one caught swimming naked.
If you have questions about how to best manage your investments and more importantly, how to manage your risk relative to your financial goals, please give me a call at 480-330-4878. I am a fiduciary. I act in your best interest. I am a fee only investment advisor. No commission sales. No minimum investment balance necessary. I work with all investors young and old no matter how much money they have.
Brad Singer, CFA is a local financial advisor and is owner of Vail Financial Advisors, a Registered Investment Advisor in the state of Arizona. This Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.
