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Portfolio Update

A Turn of the Cycle

By Elliott H. Gue, on Mar. 11, 2015

The most recent installment of Big Picture explained how high or low readings in the Manufacturing Purchasing Managers Index (PMI) can help investors to identify buying and selling opportunities early or late in an economic recovery. (See Fear, Greed and the Purchasing Managers Index.)

How can this help investors today? Last summer, PMI rallied to 58.1 after hovering below 55 from mid-2011 through late 2013, suggesting that stocks could be due for a correction in this late-stage bull market.

(Click graph to enlarge.)PMI -- Current Cycle

This warning reflects the pattern that PMI followed from 2002 to 2007 and, for that matter, in most business cycles.

(Click graph to enlarge.)PMI 2002-07 Cycle

The index began 2009 well below 40, a level that reflects a severe recession. However, by the second half of the year, the indicator surged above 55 as the economy exited recession and began to grow.

Although the US economy’s recovery from the Great Recession has been subpar by any historical comparison, PMI continued to trend higher through mid-2011. Meanwhile, the S&P 500 generated a total return of more than 80 percent from March 2009 to March 2011, as the stock market priced in an improving economy.

However, from mid-2011 to early 2013, the US entered a mid-cycle slowdown, a period where economic growth stalled, largely because of rising fear that Europe’s sovereign-debt crisis could spread to other credit markets.

The Federal Reserve in September 2012 responded to this flare-up by instituting a third round of quantitative easing—a program where the central bank purchased bonds to boost the monetary base and depress yields. In December 2012, the Fed expanded these monthly purchases to $85 billion from the previous rate of $40 billion.

These bond-buying activities continued at this level through February 2014, and the US central bank didn’t end its quantitative easing until October 2014.

Stocks didn’t fall out of bed during this mid-cycle slowdown; however, the S&P 500 endured several sizable corrections over this period, including a pullback of more than 20 percent between May and October 2011. And from spring to early summer 2012, the S&P 500 suffered a 12 percent correction.

The US economy rebounded from this mid-cycle slowdown, thanks to a combination of the Fed’s quantitative easing, stabilized European sovereign-debt markets and a gradual improvement in business conditions.

During this recovery phase, PMI climbed to a peak of 58.1 in August 2014. Investors cheered, and the S&P 500 surged by more than 50 percent from the end of 2012 to the end of last year.

However, PMI has fallen steadily since last summer. Although the index hasn’t approached levels consistent with a US recession, the economy has lost some stem over the past six months.

The Conference Board’s Leading Economic Index (LEI)—a composite of 10 forward-looking indicators and a longtime favorite of ours—has also weakened since last summer.

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