Whenever someone is looking at a map, the first thing to do is to identify their position. This creates some context to help understand the map to figure out how one can reach the destination.

Similarly, it can be helpful for investors to understand where they are in the economic and market cycle to determine realistic expectations for returns and devise a risk-management strategy. 

At the beginning of a cycle, certain behaviors and strategies are rewarded such as investing in growth stocks, buying breakouts, and using weakness as an opportunity to add exposure. In general, these tactics are rewarded by the market’s bullish trend. Later in the cycle, there’s a higher chance of reversals and failed breakouts, which makes stock selection even more paramount.

Late Cycle vs Early Cycle

Ordinarily, this exercise is pretty straightforward. We can look at various indicators like earnings yields, multiples, employment, manufacturing, capacity utilization, and interest rates to get a sense of where we are in the cycle.

However, this time is truly different due to coronavirus. Before the pandemic, we had been in a 10+ year expansion. There were some periods when economic growth softened, but it was never enough to become contractionary. There were periods when growth was relatively robust, but it was never enough to spark any inflationary pressure. 

The result was continued improvements in employment, consumer spending, and earnings. However, the economy wasn’t strong enough to generate wage growth. The lack of inflation also meant there was no constraint on the Federal Reserve from enacting a dovish policy to mitigate any economic shock. It also gave ammunition to the Fed’s critics who said that the central bank should have implemented an even more aggressive policy.

Thus, long-term interest rates continually trended lower during the expansion. For example, during the Great Recession, the yield on the 30-year Treasury bottomed at 2.5%. Despite the long expansion, the 30-year Treasury opened 2020 at 2.2%. Currently, they are at 1.65%, although they hit a low of 0.99% in March.

Current Landscape

Such low-interest rates are an early cycle phenomenon. Later in the cycle, interest rates tend to be higher due to two factors – the robust economic environment means that investors are putting money to work in riskier assets and the Federal Reserve is hiking rates to ward off inflationary pressures. 

Some of the other early cycle indicators include the dividend yield of the S&P 500 at 1.6% which is nearly double the 10-year yield at 0.89%. Previous inflection points in the market trend have come when treasury yields are significantly higher. For example, in the summer of 2007, the S&P 500 dividend yield was around 2%, while the 10-year yield was at 5%. 

Some other reasons to believe that the economic expansion is in its early stages is that we are only nine months away from the capitulation point in March at which the markets and economic data have bottomed. Since that nadir, the economy has shown improvements across all metrics. 

Other data series show that the economy is even in better shape than the same time in 2019. Due to the stimulus, consumer spending is at new highs. In previous recessions, this took years to exceed previous highs. Additionally, the Fed’s aggressive actions have ensured there is plenty of liquidity in financial markets which has boosted stock prices.

So, it’s pretty clear that we are early in the cycle especially with regards to the economy. However, skeptics might point out that record-high stock prices, frothy sentiment in various parts of the market, and high-levels of retail involvement in financial markets are not consistent with this early-cycle assessment. 

This is certainly true, however, they are consequences of the Fed’s policy which has pumped trillions of dollars of liquidity into financial markets. The reality is that Fed policy directly impacts financial markets but is shaped by economic conditions. The Fed has also signaled that it won’t be raising rates until 2022. Even after that, it won’t be hiking until inflation meaningfully rises above 2%. 

However, in terms of the economy, I believe that we are in month nine of a 24 to 30 month expansion. The frothiness in the financial markets is a concern, but we’ve had pockets of froth that managed to dissipate without any meaningful disruption to the economy.

Strategy

Entering 2020, the economy was in good shape, and a cyclical headwind was turning into a tailwind as the global economy was at an inflection point – from deceleration to acceleration. This turn was wrecked by the coronavirus which caused the bottom to fall out. 

Fiscal and monetary stimulus, in concert, with the economy’s gradual opening, has led to a stronger than expected recovery with new highs within five months of the lows. On top of these factors, we also have a normal inventory restocking cycle which was disrupted by the coronavirus but is now resuming.

Therefore, I believe that investors should stay focused on companies connected to the real economy. Many of these stocks underperformed over the last decade. 

The upturn in manufacturing and global growth, in concert with record amounts of stimulus, will lead to strong earnings growth over the next couple of years. 

Additionally, while the “frothy” parts of the market could see some bigger gains in the short-term, an improving economy will lead to higher rates which are kryptonite for these high-flyers.

Two stocks with promising prospects, under these conditions, are US Steel (X) and Cleveland Cliffs (CLF).

US Steel (X)

Over the last two months, US Steel is up 120%. This strength has coincided with a strong performance in all types of industrial stocks and commodities. It’s long overdue as this sector has been a major underperformer over the last decade. 

Since the March 2009 bottom, US Steel is up 20%, while the S&P 500 is 449% higher. US Steel continues to lose money, but in recent quarters, has been doing better than expected by analysts. As economic growth picks up, steel demand will increase.

Many expect record amounts of infrastructure spending in 2021 as governments around the world look to stimulate their economies. Industrial activity in Asian countries is also returning to pre-COVID levels quicker than expected.   

US Steel is one of the most leveraged vehicles to take advantage of accelerating economic growth. Given its strong run, some sort of reset is likely, but investors should use any weakness to add exposure.

The POWR Ratings are also bullish on X as it has a Strong Buy rating with an “A” across all categories including Trade Grade, Buy & Hold Grade, Peer Grade, and Industry Rank. Among Steel stocks, it’s ranked #8 out of 26.

Cleveland Cliffs (CLF)

CLF became a vertically integrated producer of steel and iron ore with its 2019 purchase of AK Steel. Given AK Steel’s huge debt load, it was seen as a risky move. However, CLF seems to have timed its acquisition well as both steel and iron ore prices are rising,

Further due to a decade of depressed prices, there has been little capacity increase in terms of mining iron ore or steel production. Until more projects come online, these companies will likely have increased pricing power. 

This is showing up in its earnings report as the company swung from a loss to a profit in Q3. Additionally, it expects to earn $0.47 per share next year, while it lost $0.28 per share over the last 12 months.  

CLF will benefit from many of the same factors as X – improving global growth, a strong housing market, infrastructure spending, and better-than-expected industrial activity. Investors should look to treat weakness in CLF’s shares as a buying opportunity.

CLF is also rated a Strong Buy by the POWR Ratings. It has an “A” for Trade Grade, Buy & Hold Grade, Peer Grade, and Industry Rank. Among the Industrial – Metals group, it’s ranked #8 out of 33. 

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X shares . Year-to-date, X has gained 61.23%, versus a 15.44% rise in the benchmark S&P 500 index during the same period.

About the Author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles. More...

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