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Preparing for the Macro Regime Shift to the “Overheat Phase”

Legendary speculator, Jesse Livermore, credits the following realization with transforming his trading game and turning him into one of the greats. He said:

Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.

A man must study general conditions, to size them so as to be able to anticipate probabilities….

This truth was realized by market wizard Michael Marcus over half a century later when he came up with the “Marcus Trifecta of technicals, fundamentals, and market tone.” Both traders, like all the greats, were aware of the importance of macro and keeping a finger to the wind to anticipate major changes in general conditions.

Interview Are Commodities Getting Ready for a Big Move?

The importance of understanding general conditions is why we always start from a top-down perspective. We know the majority of our market returns will be driven by macro factors.

And more importantly, we need to be white on rice focused on the inevitable changes in these conditions. It’s in correctly anticipating these large transitions — or what we refer to as inflection points — ahead of the market where the macro speculator makes his beans.

We’re seeing one of these macro inflection points play out right now. The market is not prepared for it. This means it’s time for aware macro traders to reap their harvest.

I’m referring to the turning of the Investment Clock. And the return to higher trendline growth and inflation, as the business cycle, progresses to the later stages and economic capacity tightens.

This is the dominant macro thematic we are tracking and which will play out over the next 12-months. It’ll have numerous and drastic impacts on every area of global markets.

It’s going to change the trend in currencies, precious metals, commodities, big tech stocks, bonds, emerging market stocks and so on. It’s a straight up macro regime change; the era of low volatility and subsequent melt-up in equities is coming to an end.

For those of you not familiar with the Investment Clock concept you can read a full rundown from one of our earlier articles, here. And here’s an overview of the idea.

Read The Investment Clock

The Investment Clock splits the business cycle into four phases. Each phase is comprised of the direction of growth and inflation relative to their trends. You can see these four phases in the chart below via Merrill Lynch.

Here’s a breakdown of each phase.

Phase 1 – Reflation phase: Growth is sluggish and inflation is low. This phase occurs during the heart of a bear market. The economy is plagued by excess capacity and falling demand. This keeps commodity prices low and pulls down inflation. The yield curve steepens as the central bank lowers short-term rates in an attempt to stimulate growth and inflation. Bonds are the best asset class in this phase.

Phase 2 – Recovery phase: The central bank’s easing takes effect and begins driving growth to above the trend rate. Though growth picks up, inflation remains low because there’s still excess capacity. Rising growth and low inflation is the Goldilocks phase of every cycle. Stocks are the best asset class in this phase.

Phase 3 – Overheat phase: Productivity growth slows and the GDP gap closes causing the economy to bump up against supply constraints. This causes inflation to rise. Rising inflation spurs the central bank to hikes rates. As a result, the yield curve begins flattening. With high growth and high inflation stocks still, perform but not as well as in phase 2. Volatility returns as bond yields rise and stocks compete with higher yields for capital flows. In this phase, commodities are the best asset class.

Phase 4 – Stagflation phase: GDP growth slows but inflation remains high (sidenote: most bear markets are preceded by a 100%+ increase in the price of oil which drives inflation up and causes central banks to tighten). Productivity dives and a wage-price spiral develops as companies raise prices to protect compressing margins. This goes on until there’s a sharp rise in unemployment which breaks the cycle. Central banks keep rates high until they reign in inflation. This causes the yield curve to invert. During this phase, cash is the best asset.

This was pulled from our September Macro Intelligence Report (MIR) went out to subscribers on Sep 1st.

In the report, we detailed how the data is indicating we’ve reached a macro inflection point and are transitioning to Phase 3, or the Overheat phase, of the Investment Clock.

This means that both GDP growth and inflation will begin to pick up in the coming quarters. We also noted how the market, or central bankers, weren’t positioned for this inflection point at all. In fact, we’re seeing this phase shift at the same time that the popular narrative of “secular low inflation for longer” has become consensus.

Here are two examples, out of many, of the data we’re tracking that tell us both higher growth and higher inflation are around the corner.

In market terms, this is called a FAT PITCH.

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About the Author

Co-Founder, Analyst