| The business cycle is a long-term pattern of changes in Gross Domestic Product (GDP) that follows four stages - TTW |
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| February 3, 2008 |
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The Business Cycle
The business cycle is a long-term pattern of changes in Gross Domestic Product (GDP) that follows four stages: expansion, prosperity, contraction, and recession. After a recessionary phase, the expansionary phase can start again. The phases of the business cycle are characterized by changing employment, industrial productivity, and interest rates. Some economists believe that stock price trends precede business cycle stages. As a result the economic cycle provides the strategic framework for economic activity and investing. The business cycle affects employees, employers and investors. For example:
- The economy is strong, people are employed and making money. Demand for goods -- food, consumer appliances, electronics, services -- increases to the point where it outstrips supply. This demand fuels a rise in prices, or inflation.
- As prices increase, people ask for higher wages. Higher employment costs translate into higher prices for goods, fueling an upward spiral effect.
- When prices get too high, consumers decide goods are too expensive and demand decreases. When demand decreases, companies lay off workers because they don't need to make as many goods or provide as much service.
- Decreasing demand fuels declining prices, which means the economy is in a recession.
- Lower prices spur demand. As demand picks up, people begin buying again, fueling the need for greater supply. And the cycle goes back to the beginning.
When the business cycle doesn't run smoothly, it can have consequences as disastrous as the Great Depression. That's why governments intervene to try to manage the economy. For example, if it appears that inflation is rising too quickly, the Federal Reserve (the central bank of the U.S. charged with handling monetary policy) may decide to raise interest rates to curtail spending. On the other hand, if the economy is performing poorly, the government may lower taxes to spur consumption and investment.
Interest rates and the yield curve play a very important role in determining economic activity and the performance of the stock market. Higher interest rates increase the costs to businesses and individuals. Companies must pay more to borrow money for capital investments or to fund daily business operations. Individuals pay more for mortgages as well as other loans they may take out to purchase products. Higher interest rates also increase the demand for money to invest in bonds taking money that could or was invested in the stock market.
The yield curve is a plot of the yield on bonds with the same credit quality across different maturities (the link above provides an interesting interactive model of the "living" yield curve). The basic assumption is you get more interest on your investment in a bond by holding it longer. The theory states there is more risk for holding a bond for 10 years than for 5 years, or for 5 years than for 90 days. Bloomberg provides a current chart of the yield curve for U.S. Treasuries at Bloomberg.
As the economy grows and expands the Federal Reserve usually raises interest rates to try to control inflation. When the economy contracts the Federal Reserve will lower interest rates to try to stimulate demand by lowering the costs of borrowing. If you hear that the Federal Open Market Committee (FOMC) has raised or lowered rates, they are actually raising or lowering the federal funds rate for banks. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
The business cycle has implications for markets and investors. Broadly, a recession often corresponds with a sustained period of weak stock prices, or a bear market. And a healthy, expanding economy that keeps inflation from rising too quickly often corresponds with a bull market, or period of sustained market growth.
Fortunately, there are investment strategies for all parts of the cycle, thanks to the diverse economy we have. Companies that do well when the economy is experiencing good times are called cyclical stocks. Industries that fall under this group include travel and leisure companies, airlines, consumer electronics firms and jewelry makers. Companies that make goods that are necessities, such as food and health care are called non-cyclical stocks. These stocks tend to provide more stability during an economic downturn. During an economic expansion one should invest in cyclical stocks. On the other hand during an economic contraction one should consider investing in non-cyclical stocks.
The hard part in all this is identifying where the economy is in the business cycle. As you might realize this is no easy matter and many economists get it wrong. There are many indicators that get published on a regular basis that people use to monitor the economy. Unfortunately, there isn't a simple way to make this strategic decision. The best policy is to not try to predict the business cycle, but rather to monitor the economy looking for signs that it is changing direction. The change in direction takes many months so you have time to make your observations. Keep in mind that the stock market is considered a leading indicator and will attempt to forecast that the economy is beginning to level off or contract and pull back. Unfortunately, these can be false indications as well.
Start by monitoring the performance of the economy carefully, observing overall economic performance and interest rates. Pay particular attention to FOMC announcements and changes in interest rates as well as the overall yield curve. Also, monitor the earnings announcements and conference calls of companies in key sectors, looking for changes in the economy. If companies are reporting growing earnings and beating expectations, then that is a sign the economy is likely in an expansion phase. If earnings are declining and less then expectations, it is a sign we are entering a recessionary phase. Be sure to examine all possible indications and not just earnings announcements. Finally, do not listen to the talking heads on any of the business TV stations, as very few of them have any idea of what the economy or the market will do.
Once you have decided where you think the economy is within the overall business cycle, begin to research companies that will benefit most from your overall analysis. For example, if we believe that the economy is at the peak of full recovery and is likely to be entering the early recessionary phase, then we should be looking for the best value companies in the Staples, Services, Utilities and Finance sectors. Notice, I do not suggest focusing on only one sector, but rather several that span the current stage of the economic cycle. This gives your portfolio some diversification while still following the sector rotation model.
Trading with the trend is the best way to generate profits as an investor and trader. If only we could determine which way the market is trending. Fortunately, the stock market does move in cycles, short term (also called cyclical), and long term (also called secular). Secular markets typically can last between 10 to 20 years, while cyclical markets usually last between 2 - 3 years on average. Think of a secular market as the primary long term trend, while a cyclical market is simply a shorter term cycle within the primary long term secular market.
As investors and traders, we need to understand where we are within these market cycles, so we can be on the right side of the trend to enhance our success. For example, the market was in a secular bull market from 1982 - 2000, experiencing a strong primary uptrend where the S&P 500 increased over 15 fold from about 100 to 1553. Of course, there were short term bear markets such as in 1987, however the easy money was made on the long side as the primary trend was up.
However, here's where the danger lies: The majority of investors today have only experienced a secular bull market, such as the one from 1982 - 2000. Most people have not experienced a long term secular bear market where the primary trend is mostly sideways to slightly down. The last secular bear market lasted 16 years from 1966 to 1982. Just to give you some perspective, the Dow Jones hit a high near 1000 in 1966, and hit a low in the 800s during 1982. In other words, the Dow essentially was flat for 16 years. During this time, the 'easy money' was not made on the long or short side, but by being being a good stock picker: identifying undervalued opportunities, special situation stocks, and sectors that are temporarily strong. Understanding whether we are in a cyclical bull or bear market greatly enhances our chances for success.
The graph below, courtesy of StockCharts.com, shows these relationships and the order the key sectors respond to the economic cycle. The Stock Market Cycle precedes the Economic Cycle as investors try to anticipate how the market will react to the changes to the economy.
$SOX--Best Early Cycle Performers
$NWX--Best Early Cycle Performers
$TRAN--Best Early Cycle Performers
CSX--CSX Corp (Railroads)
CHICAGO, Jan 22 (Reuters) CSX Corp (CSX.N) on Tuesday reported a better-than-expected quarterly net profit as strong pricing offset higher fuel costs and weaker freight volumes, sending its shares up more than 4 percent. The results came on a day when U.S. markets slid due to investor fears of a recession.
CSX Chief Executive Michael Ward said that he did not expect a downturn, and the U.S. Federal Reserve's 75-basis-point interest rate cut should boost the economy. "We still see growth in the economy this year," Ward told Reuters... "It will be slower growth, but I don't think we'll see a recession." Fourth-quarter net income rose more than 5 percent to $365 million, or 86 cents a share, from $347 million, or 75 cents a share, a year earlier....
Profit increased to 85 cents a share from 57 cents. Wall Street analysts had expected 64 cents before one-time items, according to Reuters Estimates.
"Any way you slice it, this was another solid quarter of double-digit earnings growth driven by improved productivity and solid pricing," CSX reported surface transportation operating income of $609 million, compared with $505 million a year earlier...........See Blog Entry
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