Sean Gallup/Getty ImagesNews

Over the past few weeks, we’ve seen a steady stream of headlines regarding the geopolitical flare-up between Russia and Ukraine.

One day tensions are high and full-scale war is imminent, and the next day peace is back on the table.

Investors trying to understand the implications of this latest geopolitical event find themselves with a whiplash, constantly moving back and forth, hanging on every headline. This is a dangerous way to handle geopolitical events for most investors.

How should investors think about geopolitical events and their investments?

There is a simple way to manage and even profit from these events that requires no political expertise.

Let’s be honest, the same people who were yesterday’s COVID analysts are today’s political commentators. No one can wear 100 different hats and translate these one-off events into concrete market insights.

Most investors should certainly watch and stay on top of major events, but should stay focused on the underlying cyclical trends.

Every economy has long-term (secular) trends and short-term (cyclical) trends.

For more color on these trends, you can watch a short video I put up on the EPB Macro Research homepage, but for now we’ll focus on short-term cyclical trends. .

Cyclical trends are defined by the direction of actual growth over 6 to 18 months.

We focus on the direction of growthincreasing or decreasing, not the level of growth.

When growth picks up, we call it a “cyclical recovery”.

When growth declines, we call it a “cyclical slowdown”.

All crashes and negative events occur during cyclic slowdowns.

In short, when the economy is experiencing a cyclical recovery, geopolitical events do not matter, and any pullback in the market created by external fear is a significant buying opportunity. When the economy experiences a cyclical downturn, any external shock can exacerbate the downward momentum and push the economy into a recession.

Let’s take a deeper look.

A macro manual for political events

At EPB Macro Research, we define the cyclical trend by the direction of growth over 6 to 18 months, measured by an aggregate index of real income, real consumption, industrial production and employment.

This index takes the most reliable measure of the four corners of the economy, smashes them together, and tracks the trend rate of growth.

When the economy experiences a cyclical recovery, external “shocks” never create a risk of recession, as the upside momentum cuts through adverse events.

Conversely, when the economy is in a cyclical downturn, already on a bearish momentum, a negative external shock can exacerbate this momentum and plunge the economy into a recession.

Therefore, investors should position themselves on the cyclical trend of the economy first, not political headlines.

Take 2016 as an example. In 2016, there were two “shocks” defined as unexpected market events. First, in June 2016, there was an unexpected result of the Brexit vote, then in November 2016, the US election was a surprise in favor of former President Trump.

From 2014 to early 2016, the economy experienced a cyclical downturn and was highly vulnerable to external shocks. In the spring of 2016, the economy started to recover and a cyclical recovery developed.

In June 2016, a major shock hit the global economy, marked by the red “X” in the graph below.

Coincidental growth trend

Federal Reserve, BLS, BEA, EPB Macro Research

The S&P 500 corrected sharply but almost instantly returned to new highs. Why? Because the cyclical recovery was underway and external shocks were ignored.

You might wonder how we knew the cyclical recovery was underway in June 2016, and that’s a great question. The chart above shows a “coincident” index. Coincident indicators define the trend, but they don’t tell you where the economy is going. Leading indicators tell you where the economy is going.

An example of a leading indicator is the gap between new orders and inventory. June 2016 is again marked by the red “X” and you can see how this leading indicator rose several months before the shock.

Numerous leading indicators had emerged in early 2016, alerting cyclical investors that an economic recovery was underway.

Main indicator

ISM, EPB Macro Research

During the November 2016 election, the economic recovery was in full swing and the surprise results prompted another brief decline followed by a return to all-time highs.

The chart below shows that when the economy experiences a cyclical recovery, external shocks create very rapid lows, followed by a return to historic highs.

When the economy experiences a cyclical recovery, any fear-based decline is a buying opportunity.

The S&P 500 almost never has a correction of more than 10% during a cyclical recovery.

2016 S&P 500 Drawdowns

Y-Charts

During a cyclical downturn, however, corrections can turn into crashes.

Today, the economy is in a cyclical downturn defined by the same coincident index below, which means the ongoing geopolitical risks are dangerous and not worth considering.

With bearish momentum already underway and leading indicators showing no signs of an impending inflection, any external shocks can push the growth rate even lower towards contraction.

Coincidental growth trend

Coincidental growth trend (Federal Reserve, BLS, BEA, EPB Macro Research)

The S&P 500 is already down more than 10% from its peak at the time of writing, which is a common symptom of an economic downturn and a rarity during a cyclical recovery.

Current S&P 500 drawdowns

Y-Charts

So what should investors do?

The first thing any investor should do is position themselves for current cyclical trends. When the economy is in a cyclical upswing, it’s time to be very aggressive and take big risks.

When the economy experiences a cyclical downturn, it’s time to play defensive, protect gains and stay cautious.

There is no need to worry about external events once you are well positioned for cyclical trends.

If the economy is in a cyclical recovery and you are positioned aggressively, you know that any decline is a buying opportunity and a chance to get even more aggressive.

If the economy experiences a cyclical downturn, you are already positioned defensively, so no external shocks will impact your portfolio.

Right now the economy is in a cyclical downturn, so you should already have been positioned defensively.

The manual for surviving and benefiting from geopolitical events is to use them to your advantage, playing on the underlying cyclical trends in the economy that you are already prepared for.

Legendary Treasury bond investor and renowned economist Dr. Lacy Hunt said:

Shocks cannot stop or reverse a phase of the economic life cycle…they can (only) delay its progress for varying periods of time.”

The economy is in a cyclical recession. This means that we should all hope for peaceful results from geopolitical events, but we should not catch a falling knife. A peaceful resolution may cause a strong rally, but once the dust settles, the market will still have to deal with the current downturn in the economic cycle.

Step 1: Use coincident indicators to define the current trend

Step 2: Use leading indicators to prepare for the months ahead

Step 3: Position for current/upcoming cyclical trend

Step 4: Take advantage of political risks – already in position for underlying trends