The Business Cycle and Market Rotation:
One long trend of economic growth has characterized
the history of the United States. Since the creation of
the original colonies until today our nation has made
technological leaps and bounds to the point where its
people enjoy the highest standard of living in the world.
However, this trend of economic growth has been
interrupted by periodic economic cycles of recession and
depression.
Economists call this cycle of growth and contraction the
business cycle. These recurring ups and downs in
economic activity last through several years. Economists
have blamed these fluctuations on technological
innovations and their impact on investment and
consumption, monetary policy, or external events such
as wars and changes in the price of commodities.
Business cycles are made up of peaks, recessions,
troughs, and the recovery phase. The peak is when
business activity has reached its maximum levels. The
economy has low unemployment and domestic output is
close to total capacity. This is followed by a recession
during which output, income, employment, and trade
decline sharply. This downturn usually lasts between 6
to 12 months. It is generally the shortest phase of the
business cycle. The recession period is followed by a
cycle trough during which business activity reaches its
lowest levels. This phase can be very or quite long. The
Great Depression and 1970s era of inflation and
recession were both extended trough periods. The final
phase, recovery, is when the economy expands towards
full employment and maximum output.
The movements of the financial markets are closely
linked to the business cycle. Price trends in the three
main markets, stocks, bonds, and commodities, are
heavily influenced by investors expectations of the
future. Each financial market tends to peak and bottom
at different points in the business cycle. Therefore, one
can study the financial markets to determine broad
trends in the economy.
An expanding economy is generally favorable for the
stock market, a weak economy for bond prices, and an
inflationary economy for commodities, especially the
price of gold. Let's exmaine the bond and stock markets
to see what they are telling us about the future of the
economy and what might be the best place to invest in.
A growing economy is generally bullish for stock prices
and bearish for bonds. The bond market tends to lag
the overall economy. The bond market usually begins its
first bull phase when the economy begins to slow down
from it's peak rate. Bond prices also top out and begin
to fall as the economy begins a recovery phase. The
sharper an economic contraction the greater the rise in
bond prices usually are.
The most important bonds are government treasury
bills. Investors all of the world use them as safe havens
when there is political or economic turmoil. Economists
have found that the point spread between 3 month
Treasury bills and 10-year treasury notes is the best
predictor of future economic activity and recessions.
Throughout the year the treasury bills spreads have
continued to widen and are now at -.18%. A Federal
Reserve study found that a value of -.18% indicates that
there is more than a 30% chance of a recession within a
year. You can read their study at .
The overall stock market tends to lead the general
economy. Unlike the bond market, however, the stock
indexes go up before the economy peaks and fall before
it begins a recession. However, the stock market is made
of a companies from various economic sectors. These
sectors, and their stocks, rotate during different phases
of the business cycle. A careful study of what these
individual stock sectors are doing gives a much better
read of how the stock market is factoring in the
economy than just looking at the major averages does.
Economic recoveries are often led by consumer
spending and drops in consumer spending often lead
economic contractions. The retail stock sector, likewise
is a leader of the broader stock market and the economy
and is usually one of the earlist sectors to peak out and
to bottom. The same holds for the housing and
construction industries, which are heavily influenced by
interest rates. As interest rates are cut demand in these
sectors grow and so their stock prices. The industrial
and manafucturing sectors usually follow the moves of
the retail and construction industries. As inventories
become depleted demand for more manufacturing and
industrial ouptput increases.
Since the stock market leads the economy these stocks
bottom out and recover as investors factor in economic
recovery, more consumer spending, greater construction
spending, and a growth in industrial output before
these events occur. However, because the economic
enviroment and news are often still bad investors are
fairly cautious and first place money into companies
with god earnings and cash reservces. As a bull market
cycle grows though, they will place money into more
speculative stocks such as technology companies. At the
tale end of the bull market the hot sectors become these
the market leaders. The larger the speculative bubble
the worse the next market downturn becomes.
At the beginning of a bear market money flows out of
speculative issues and into safe havens, including bonds,
high-dividend yield stocks, and staples such as food and
drug stocks. This is exactly what we have been seeing
over the course of this year. The top performing sectors
have been utilities, drug manafucturers, and companies
such as Pepsi.
We are also seeing a complete breakdown in retail
stocks. Although consumer confidence and spending
numbers remain high the retail stocks have been
breaking down. The stock market is confirming what
the bond market is hinting: an economic slowdown is
coming. We are already in a bear market and I do not
see any bull market return until these retail stocks
bottom out. |
