The Investment Philosophy
The philosophy is based on a historical fact that stock markets over time move upwards in a cyclical way. The cycles are irregular and have various length and characteristic.
To maximise profits in the rising and cyclical environment investors should have long (buy) positions during the cyclical upswings in the largest equity markets such as the USA and avoid or reduce equities exposure during cyclical downturns. The ideal investment vehicles for that are broad market indexes and the key question of course is how to identify the major turning points in the cycle.
Passive index investing is a sensible strategy in generally rising market. The costs are low and diversification broad. Returns can only match the “beta” market performance. Less satisfactory returns will occur when the long term market trend is flat of falling.
The best performing investment managers need to have tools that more accurately predict cyclical upswings of the market to know when to increase exposure and leverage their positions in the market index to produce the excess “alpha” returns. We have in mind the market upswings that run for months and years and not the daily and short term random and practically unpredictable movements.
That brings us to the need to understand the cyclical nature of the asset prices and the role of fundamental macroeconomic forces driving corporate profits that in turn underpin stock valuations.
Nobody can question the existence of business & economic cycles and connected with it profit cycles; there is 100 years of evidence, research and theories trying to explain it. The difficulty is in an ability to consistently and accurately pinpoint in advance the turning points in the cycle given that each cycle is different and countless forces may play a role.
That is where our proprietary methodology adds the key informational value: by being more accurate and consistently correct in identifying the major turning points of the cycle.
Interest Rates and USA Stock Market: "Buy & Hold" strategy will not work in the future
The value of the methodology should be even more significant in the long term because the future US stock market performance is likely to be subdued – like it was in a weak 30-year period 1951-1981 mainly due to rising interest rates environment from around low 2% to high 18%.
Investors should be careful not to extrapolate into the future the spectacular returns of the past 27 years (1981-2008) that were largely driven by a falling interest rates environment from 18% down to low 2%-3%. Please refer to graph below depicting performance of Dow Jones Index (black line) Vs USA Overnight Interest Rates (red line) over 57 years period 1951-2008 to see the big inverse impact of the interest rates direction on the stock market performance:
Future interest rates cannot go much lower from the current low levels and it is reasonable to assume they will be rising at some point or stay flat on average. The stock market should be cyclical and subdued in such environment. A “buy & hold” strategy will not produce good returns in such circumstances; only timing of the index should have a better chance of delivering superior alpha.
Stock market follows aggregate Corporate Profits
The proprietary Business Cycle Index developed by George Bijak is an effective leading indicator of the major turning points (not all) in corporate profitability for the whole USA economy. The aggregate US Corporate Profits are calculated quarterly by the USA Government and published in National Income and Product Accounts (NIPA) at www.bea.gov where subscribers may independently verify the forecast.
The U.S. Corporate Profits have been historically highly (93%) correlated with the major diversified USA stock market indexes: Dow Jones Industrial Average (DJIA) and S&P 500. Hence, the Business Cycle Index can be used as a leading indicator of the broad USA stock market.
The Corporate Profits for the whole US economy don't always move in the same direction or by the same magnitude as the profits reported by individual companies or even the DJIA or S&P 500 (refer to "Comparing NIPA Profits with S&P500 Profits" by Kenneth A. Petrick).
Validated Methodology
The proprietary methodology was validated over more than fifty years of historical data. The Business Cycle Index, first developed and published in 2004, proved to be a consistently accurate indicator of economic conditions that led to major turning points in the Corporate Profits and correlated with it broad stock market indexes.
The forecast specifies average direction of the US Profits and broad stock market over the following quarter and does not attempt to set target values.
The formula is particularly useful for signaling major turning points of the very lucrative periods of the broad stock market when most stocks perform well and stock picking is almost irrelevant. Such periods called “IN the market Periods” represented around 30% of time, lasted historically on average 15 months and occurred on average every 4 years ranging from a few months to a few years and each cycle was different – see performance tables and graphs.
The "OUT of the market Periods" represented on average 70% of time lasted around 3 years ranging from a few months to many long years. They were volatile times and 4 in 10 OUT Periods experienced a major stock market crash. Our quarterly forecast formula, while very useful for identifying the beginning and end of the OUT Period with great consistency, is less useful during the OUT period from quarter to quarter. Patient investors will appreciate however, that at the end of the OUT Periods the overall returns were mostly in single digits around 2% on average and below cash rate - not worth the risk - even though the market may have had large unpredictable gains and losses on the way.
How is this possible?
We do not believe it is feasible to forecast the economy and stock market in the short term on daily, weekly or monthly basis with consistent accuracy. Economy and stock market are far too complex systems influenced by countless independent and unforeseeable forces. Statistical methods, Chaos, Random Walk and Efficient Market theories explain why it is impossible although some of the theories were eroded by succession of discoveries and anomalies (see for example Robert Shiller 2002). Many professional investors supported by high caliber scientists lost fortunes trying to predict short to medium term market using the most sophisticated artificial intelligence and statistical methods.
The Business Cycle Investor model takes a different approach that has nothing to do with statistical tools or finding a "curve fitting" formulas using artificial intelligence and mathematical methods.
The proprietary formula measures a state of the macroeconomic conditions that historically preceded the turning points in the average direction of the US Corporate Profits and broad stock market.
The proprietary model does not attempt and cannot predict the exact values of the Corporate Profits and Dow Jones index or any other economic indicator on a particular day during the forecast period or at the end of the next quarter.
There are unpredictable risks in any stock market forecast and there are no 100% guarantees. The market does not always behave in a rational way. Speculation and market sentiment sometimes dominate over macroeconomic fundamentals although less so in the beginning of a trend. Warren Buffett captured the essence of the speculative behavior when commenting on bubbles: "..like most trends, a bubble is driven by fundamentals at the beginning and then speculation takes over. As the old saying goes, what the wise man does in the beginning, fools do in the end"
Unexpected spike in oil prices to record levels was historically the main unpredictable risk factor. The stock market reacts to it without delays, be it for a short time, even disregarding positive long term macroeconomic forces that normally stimulate the Corporate Profits. Another uncontrollable events include natural disasters, wars, acts of terror on a large scale and other X-factors that can move psychology of the market and short term direction of the economy and the stock market with negative consequences for investors.
In this game, one can only aim to improve the chances of being right.
Weather forecast example
A good illustration of the new methodology is a case of weather forecasting because climatic system is also very complex and influenced by many unpredictable forces.
Due to the complexity of the system, it is not possible to consistently forecast accurate temperature for the next day, week or month in a specific city. No wonder that weather forecasters have rather miserable track record. Similarly, some stock market advisors are trying to guess short term individual stocks movements - needless to say with poor results.
However, reliable weather forecasting is possible if one would only concentrate on the longer term average temperatures and turning points aligned with seasonal patterns. Knowing for example, that we are at the end of Spring we can be fairly sure that the average temperature over the next few Summer months should be higher. Why? Because there are historically proven cyclical seasons and Summer is on average warmer than Spring. Delays in the climatic system ensure it takes months to change the direction of the average temperature and once we enter the Summer season it will get gradually warmer. Sure, some days may be colder than others but the average temperature should go up.
So, if our weather forecaster was "less ambitious" and made in March a prediction that the average temperature in the USA in July will be higher than in March, he would most certainly be right and we should trust such forecast.
The Business Cycle Investor approach is similar to the "less ambitious" weather forecast, although each business or economic cycle could be extremely different and not as regular as the weather's seasonal patterns. The proprietary model measures economic conditions every quarter to determine if this is the beginning of “Summer” or “Winter” environment for the aggregate US Corporate Profits and US stock market. Historical data helped to establish an average neutral value of the Business Cycle Index – an equivalent of Spring and Autumn seasons. When the index goes above the average level it is time to go "IN the market" (Buy), when it drops below the average it is time to get "OUT of the market" (Sell). The exact value of the Business Cycle Index is therefore less relevant and only the times of crossing the empirical average line carry key information value about the turning points - that is why this website presents only a "binary" version (IN or OUT of the market) of the Business Cycle Index on the performance charts.
The validated model is now being used to make quarterly outlooks for the Dow Jones Industrial Average index with good results.
How to use our buy & sell signals
Investment Banks, Institutional Investors and Hedge Funds use the research for timing the USA stock market index, proprietary trading (directional & pair trading strategy -contact us for details), global asset allocation and leveraged strategies decision support using broad USA market index funds, index futures and index derivatives.
