5troughs of bonds, stocks and commodities are also part of that sequence. Each of these three markets has two turning points, giving us the six stages. Stage I begins during the early part of the recession when rates peak and bonds bottom. That's when the demand for credit plummets because of declining business activity and the supply of credit, through Fed actions, is expanding. Whenever demand shrinks and supply expands, the price of anything declines. In this case, the price of credit is interest rates. Even though stocks are falling in Stage I, some interest-sensitive early leaders, such as utilities or even homebuilders, start to edge their way higher. Eventually, the players in the equity market sense that the declining rates will soon lead to a recovery. So instead of waiting for a recovery, they anticipate it. They say the news is blackest at the bottom. In the case of the stock market, the final low is often associated with the lowest point in the momentum of coincident indicators, such as industrial production. Insights: Is this what triggers a rally?Martin: Exactly. Our research has shown that Stage II actually offers the best and broadest stock market gains. Eventually business picks up to the extent that commodity prices bottom out. So now all three markets are in a rising phase, and that's Stage III.But, all good parties must come to a close. At some point, Stage IV hits. This is when the demand/supply balance for credit tips in favor of the demand side. That means bonds peak and start their bear market.In Stage IV, rates might be rising but stock market participants are still positive because profits are moving up at a faster clip than interest rates. Insights: So what slows it down?Martin: Eventually the rate rise takes its toll on equities, which now peak. This often takes place when momentum in the coincident part of the economy is topping out.BONDSSTOCKSCOMMODITIES4 to 5 YearsPring's Six Business Cycle StagesSTAGE 1STAGE 2STAGE 3STAGE 4STAGE 5STAGE 6SELL BONDSDEFLATIONARY PERIODRECESSIONSELL STOCKSSELL COMMODITIESBUY BONDSBUY STOCKSBUY COMMODITIESEXPANSIONINFLATIONARY PERIOD
6Welcome to Stage V. This is where most stocks start to decline. While you might have some lagging sectors-such as mining and other resource-based equities-eking out small gains, the broader market starts to fall.Economic activity either slows down or contracts so that commodity prices enter a bear market, thereby signaling Stage VI. This usually happens just before or just after the recession has begun. After a while, we're ready to start the cycle again. Now in some instances there's no recession; just a slowdown in the growth path of the economy. The six stages still operate, but because the gyrations in the economy are less dramatic, volatility in the financial markets is also reduced.Insights: What stage are we in now? Martin: We're currently in Stage II.Insights: How do you determine the current stage? Martin: We use three models: one each for bonds, stocks and commodities. Their status, according to a metric we call "Pring Barometer" scores, determines the stage. For example, if they're all bullish, we're in Stage III. They're all bearish? Stage VI, and so forth. Insights: Can you describe your Pring Barometer scores in more detail? Martin: Each barometer comprises several components. Each has been fairly reliable in the past but certainly not perfect. When the majority of components are positive, so is the barometer. The actual formulas are proprietary. But I can tell you they include trend-following indicators as well as inter-asset relationships. Insights: What input data feed into calculating them? Martin: All of the data are market-driven. Some are published by the Fed. We also incorporate market benchmark data, such as commodity index performance.Insights: How do these scores factor into asset allocation?Martin: The barometer score for each asset class determines its target allocation. For example, commodities consistently lose in Stage II, but that's when stocks do best. Consequently, there's no allocation to commodities or commodity-driven stock sectors in that stage, but a big one for equities in general. At the inflationary back end of the cycle, Stages IV and V see greater allocations to commodities and resource-based stocks and so forth.The approach can only work if the baseline philosophy is properly allocating during each phase.Insights: How did the idea for creating an index based on your investment process come about? Martin: Steve Malinsky of Dow Jones Indexes read one of my books covering the business cycle and felt that the approach would make a great foundation for a dynamic index. I thought it was a great idea, and we began our collaboration.Insights: How did you test your theories to make sure they were usable in the index?Martin: When we devised the Dow Jones Pring U.S. Business Cycle Index, the first task was to develop three models-one each for stocks, bonds and commodities. These were then tested back to the 1950s to ensure they could meet the stresses of a deflationary, inflationary and financial crisis environment. Once we had decided on the stages, we researched which assets and equity market sectors performed the best in each stage. We then selected the best combination.Insights: How does risk come into play?Martin: Good question. The index uses our philosophy which is intended to minimize risk by avoiding or downplaying assets when the business cycle phase is hostile for them. So, for instance, it's going to downplay bonds when commodities and inflation are up. Insights: How have you found working with Dow Jones Indexes? Martin: My experience with working with Dow Jones Indexes was very enjoyable. They never overpromised and always delivered on their commitments.