The economy is a very sensitive and delicate mechanism. Small changes in growth rates put forces in motion that have a major impact on economic behavior from changes in business profitability to the value of assets. Everything from commodities to stocks, from interest rates to precious metals and currencies is affected. Oil or lumber may soar one year and decline the next. Gold and real estate were the hot investment in the 1970s and the dramatic losers in the 1980s and 1990s. Bonds collapsed in the 1970s, but provided returns up to 40% after 1982. As a business and financial strategist, how do you predict when and in which direction these changes will occur? The essential driving force that moves the prices of all assets is how fast the economy grows relative to its long-term growth rate.

Asset prices change depending on how fast the economy is growing relative to its long-term average pace. The long-term growth rate of an industrialized country is usually around 2.5%. The average long-term growth for the U.S economy after 1982 is somewhere between 2.5% and 3.0%. We will also call this growth potential. The average growth of 2.5 - 3.0% represents how fast the economy can grow on average during normal conditions.

But growth is very rarely at its 2.5 – 3.0% potential. Sometimes it speeds up above this range and other times it slows down below it (Fig.4-3). We will further investigate the reasons for this variation later. Values of assets respond to whether business growth is above or below its long-term potential. In order to develop guidelines that can be used for investment strategies, it is useful to follow what happens to the business cycle as it moves through four main phases.

Phase One
Phase one of the business cycle occurs when the economy comes out of a period of very slow growth, well below its growth potential. The growth rate increases but does not exceed the growth potential. When the economy grows at a pace below the long-term average pace, the economy could well have been in a recession.

The business cycle goes through four phases, releasing forces that drive asset prices and financial markets.

But investment strategies developed over a period of very slow growth or recession are the same because asset prices act in the same way in both cases.

Phase Two
Phase two of the business cycle occurs when growth rises above the growth potential. For instance, if the average long-term growth of the economy is assumed to be 3%, phase two of the business cycle takes place when growth of the economy rises above this level. These are the boom periods when everything seems to be going right and terms such as “Goldilocks economy” are used.

Phase Three
In phase three, economic growth declines to the growth potential. This phase identifies the beginning of the correction created, as a result of the policies followed by the Fed in phase one and phase two.

Phase Four
In phase four, growth declines below the average growth potential. All the excesses created in phase two and three are brought under control in this period. This is the time to pay the piper and offers the greatest investment opportunities for the astute investor. Although these are times when economic conditions are very poor and unemployment is rising and the mood of the nation is typically depressed, the financial markets rise quite strongly at these times, with both the stock and the bond market rising in value quite appreciably. Historical evidence shows quite clearly that as the economy strengthens and grows more rapidly, the financial markets begin to perform more sluggishly. However, as the economy slows down to the point when interest rates start declining, the financial markets provide some attractive returns. Opportunities and risk change as the growth of the economy changes from slow growth to strong growth to slow growth again. For instance, in 1995 interest rates (a lagging indicator) began to decline and the money supply (a leading indicator) immediately started to grow much more rapidly and stock prices soared. Eventually, in 1996 industrial production (a coincident indicator) began to rise.

Investment risk changes as the business cycle moves steadily from phase one to phase four. Economic growth above its long-term potential is accompanied by rising lagging indicators, such as interest rates, inflation, and labor costs. These times have been of high-risk for the stock market because returns from equities in this period have been well below average. Investment risk declines and the prospective of considerably higher profits in stocks and bonds materializes when the economy grows more slowly and its growth falls below its long-term average and interest rates and inflation decline. As the economy accelerates, as we have seen in previous chapters, it develops the forces that will make it grow at a slower pace. However, in spite of all these dynamics, the long-term average growth of the economy is 2.5 - 3.0%.

This is like what happens to a jogger. If the jogger's natural pace is nine minutes per mile, any attempt to speed up will result in a faster pulse rate, higher temperature, shortness of breath and increased fatigue. Before long, the jogger will have to slow down and coast until strength returns. Competitors know that the faster and longer joggers run above their average pace, the more likely they will have to slow down to rest and the longer it will take to recuperate.

The economy behaves exactly the same as a jogger. If the economy grows much faster than the growth potential, its temperature rises too. For the economy, this rising temperature equates with inflation, higher interest rates, accelerating wages, and high capacity utilization of machines and human resources, and eventually lower business profitability as productivity slows down. Like the jogger, the economy has to slow down under this pressure if it is to regain strength. To do this it must grow at a pace below its growth potential. Only then will inflation, interest rates, wages and capacity utilization decline and business profitability improve as costs decline and productivity improves.

As the growth of the economy changes, profitable trends develop. Before we examine them, let's look at what makes the economy accelerate and slow down using the knowledge developed in the previous chapters. Later we will discuss how to predict these changes and how to time specific investment strategies. As you read the following pages, a question will emerge. If the long-term average growth rate is so important, what can we do to make it rise? Substantial research in this area indicates that increasing the country's productivity is the only answer. This can only be accomplished through improved education, investments and low inflation. It is just that simple and enormously difficult to achieve.

What happens during phase one of the business cycle?
This phase is signaled when the economy finally comes out of a period of recession or slow growth below the growth potential and starts improving again. Any change from one phase to another is a direct consequence of what happened in the prior phase. When the economy grows very slowly, inflation declines because consumers recognize they are going through difficult times and they become cautious buyers. People find it difficult to find jobs as unemployment rises. As a result, growth in wages declines and income grows very slowly. For this reason consumers watch prices very carefully, keeping inflation under control. Of course, with the economy very slow, borrowing is also subdued, and interest rates decline. A slow growth period is also characterized by slow production, and therefore, there is less need for raw materials, which weaken as slow production lessens their demand.

But there is good news during a period of very slow growth. The decline in wages, interest rates, raw materials, and inflation is reflected in lower costs for business. As a result, business profitability begins to improve at the moment when most people consider this to be the worst time of the business cycle. As the costs decline, business profitability improves.

It is important to note that the growth in wages, the decline in interest rates, and the decline in borrowing are all lagging indicators and a decline in lagging indicators means that the cost pressures - the excesses that were generated by the previous growth - are finally being brought under control. Therefore, they anticipate some improvement in the business cycle. In fact, as slow growth begins to bring costs down, and the effects of efforts to improve productivity implemented during the slow growth period kick in, profits begin to improve. For this reason, profits are an important leading indicator. Their improvement encourages business to be more aggressive in its outlook for the future and in its investment plans.

What you are beginning to see is a very important aspect of the business cycle. A decline in a lagging indicator is followed by an improvement in leading indicators - that is, a decline in cost factors is followed by an improvement in profitability.

A typical example of this relationship is what happened during the financial cycle that began in 1995. At that time, the economy slowed down and interest rates began to decline from a level close to 6%. The decline in interest rates induced more borrowing and the Federal Reserve accommodated this need for money by letting the money supply grow more rapidly. The strong growth of the money supply which began in 1995 was eventually followed by very strong growth in the economy in 1997 and 1998. By mid-1998, the pressures on inflation were rising and inflation gradually moved higher from a low 1.5% in 1998 to about 2.7% in 1999. At the same time, as inflation was rising, long-term and short-term interest rates also began to rise. The increase in interest rates during 1998 and 1999 discouraged borrowing, and as a result, the growth of the money supply peaked in early 1999. In this example, inflation, interest rates, the money supply, and the economy behaved exactly like what investors should have expected.

The reason interest rates decline during phase four of the business cycle is due to the slower growth in the demand for money because business is discouraged to borrow due to the slow growth in business activity typical of this period. However, as soon as profitability improves, demand for money increases. The Fed encourages this process by creating the necessary liquidity needed by business (the process of liquidity creation will be discussed in detail in Chapter 6 when we will review the functions of the Fed).

In phase one you see not only an improvement in liquidity, but also an increase in the growth of the money supply because the Fed has made money more available to business as well as to consumers. During a period of slow growth, as inflation declines, long-term interest rates also tend to decline, reflecting lower inflation expectations.

Furthermore, since the stock market thrives on liquidity, equity prices bottom out and start rising. There is no doubt that phase one represents a very important time of the business cycle as far as financial markets are concerned. The reason phase one is very favorable to the financial markets is because the economy slows, interest rates decline, and the Federal Reserve injects money in the system to favor the expansion. However, the increase in liquidity goes partly into the real economy. Another part of this liquidity goes into the financial markets, and that’s why the financial markets perform extremely well in this phase.

As profits continue to improve and costs remain under control, business begins to expand capacity and production and hire more people to take advantage of the opportunities. More jobs lead to more income, more sales lead to more production and even more jobs. The economic growth keeps on rising as the process feeds on itself with business increasing its profitability, the money supply expanding strongly, interest rates declining, bond yields declining, and the stock market rising. The dollar, reflecting the confidence of the international financial markets and the future of the U.S. economy, strengthens. This is the phase where the jogger - that is the economy - is finally well rested and able to begin running faster.

The major developments that take place in phase one can be summarized as follows:
• The growth of the money supply is rising rapidly.
• The dollar is improving.
• The stock market is rising.
• The growth of the economy, as measured by the growth in production, sales, income, and employment, stabilizes and improves but remains below its growth potential.
• Profits bottom and then improve.
• Commodities continue to weaken and eventually bottom.
• Short-term interest rates continue to decline and eventually bottom.
• Long-term interest rates continue to decline and eventually bottom.
• Inflation continues to decline and eventually bottoms.

What happens during phase two of the business cycle?
In this phase the momentum of the economy is so strong that growth rises above the long-term potential. Employment, production, income and sales continue to rise rapidly. As unemployment continues to decline, it becomes difficult to find skilled workers so wages begin to rise faster. Increased production places upward pressure on raw materials. Favorable economic conditions, coupled with growth in income, lead to aggressive consumer buying resulting in an increasing pace in borrowing. Eventually, higher consumer and business borrowing cause interest rates to rise. In fact, this is the time when capacity utilization is reaching high levels and business feels more and more compelled to borrow to increase capacity. But of course, as capacity utilization increases, productivity improvements slow down, as discussed earlier.

Business can no longer absorb the rising costs of commodities, labor, and interest rates. The lagging indicators are finally raising their ugly heads and warning investors that the economy is overheating and risk is increasing. The implication is that profitability is now at stake with profit margins under pressure because of rising costs.

The rise in costs is a signal that the strength of the economy is at risk because an increase in costs will force the leading indicators to decline. How? An increase in costs means that business profits are at risk and business will have to cut costs to maintain profitability. During this phase, characterized by strong growth in the economy, investors need to pay attention to those variables (mostly lagging indicators) that have an impact on decisions (leading indicators) that would cause the economy to slow down. For instance, when the growth in wages and in overall labor costs begin to rise, accompanied by rising interest rates (all these measures are lagging indicators), investors need to closely follow the impact of these indicators.

The most immediate impact of these indicators is on profitability, which is an important leading indicator, and on housing starts, which is also another important leading indicator. For instance, the rise in interest rates will cause construction activity to slow down and weakness in orders for heavy equipment because business finds investing in construction and heavy equipment less attractive because of the increased costs of borrowing.

As interest rates and inflation rise, they will have a negative impact on other important leading indicators, such as consumer sentiment and consumer expectations. As interest rates and inflation rise, income for consumers declines, thus affecting consumer attitude in a negative way. The main reason is that as inflation increases, it erodes the purchasing power of the consumer, and thus, has a negative impact on their outlook for the economy. Furthermore, the increase in interest rates raises the cost of borrowing for consumers, and this also has a negative impact on its attitude. A period of strong growth, accompanied by increasing lagging indicators, will force a series of decisions that will eventually lead to slower growth in the economy.

Like an over-confident jogger, the economy in phase two tries to run faster than it should. When this happens, the Fed eventually acknowledges that the economy may be overheating and that too much growth would bring a higher rate of inflation. Higher interest rates are, therefore, allowed to rise even further, discouraging business and consumers from borrowing. This action will cause a decline in the growth of the money supply and in overall liquidity. Slower growth in liquidity, accompanied by rising interest rates, has a negative impact on the stock market, which peaks. The strong growth that we have in phase two eventually triggers a slowdown and anticipates the events in phase three of the business cycle. As the economy downshifts, the dollar is likely to weaken, anticipating slower growth in the future.

The major developments that take place in phase two can be summarized as follows:
• The money supply continues to rise very rapidly and eventually peaks.
• The dollar remains strong and eventually peaks.
• The stock market continues to rise and eventually peaks.
• The economy, as measured by the growth in production, sales, income, and employment, grows very rapidly above the growth potential.
• The growth in profits rise rapidly.
• Commodities are very strong and rise.
• Short-term interest rates rise.
• Long-term interest rate rise.
• Inflation rises.

What happens during phase three of the business cycle?
Phase three is the most treacherous phase of the growth cycle. Growth in sales is at the highest level in years, profits are beginning to soften, but the recognition that interest rates and inflation have been rising for some time tends to lag behind. As costs accelerate and sales slow down due to business cutting costs and the Fed reducing the growth in liquidity, there are downward pressures on income, sales, employment and production. The reason is that as the growth in the money supply declines, there is less liquidity available to consumers and business to spend. This lower level of liquidity and rising inflation and interest rates force business and consumers to cut spending. The ultimate effect is a slowdown of the economy.

Of course, as costs keep rising, business is forced to cut them. The negative feedback between lagging and leading is clearly visible at this point. Business will not be satisfied to cut costs until the factors that created declining profits are brought under control. In other words, business will stop cutting costs only when the lagging indicators finally decline. A decline in the lagging indicators (for example, inflation, interest rates, growth in labor costs) is a signal that costs are finally under control. It is a signal that labor costs, commodities, and interest rates are on the way down. This is an important indication for business that their margins are likely to improve in the near future, and therefore, encourages them to start spending again. Phase three represents this adjustment and the slowdown will continue until the lagging indicators begin to decline. This is the crucial development investors have to look for in this phase of the business cycle.

The important developments that take place in phase three are the following:
• The growth of the money supply continues to decline.
• The dollar is relatively weak.
• The stock market is weak.
• The economy, as measured by the growth in production, sales, income, and employment, continues to slow down and eventually falls below its long-term growth potential.
• Profits continue to remain strong and eventually decline.
• Commodities peak and eventually decline
• Short-term interest rates eventually peak and then decline.
• Long-term interest rates eventually peak and then decline.
• Inflation continue to rise and eventually decline.

What happens during phase four of the business cycle?
Finally, the jogger has decided he just can't make it - it is time for the economy to slow down - at least to below its average pace and moves into phase four. This is, therefore, a time when the growth of the economy falls below its long-term average of 2.5 to 3%. With tight monetary policy, as the money supply continues to slow down, and with business continuing to cut costs, the economy remains weak and eventually in phase four the first signs of recovery begin to appear. As the economy grows very slowly, inflation peaks and then starts declining. Consumers aren't buying much because of rising unemployment rates due to business cost-cutting programs. Interest rates, due to lower inflation and slower growth in the demand for credit, start to decline. Commodities weaken because of slow demand caused by the economy and slow growth in production. The dollar, reflecting all these uncertainties, remains weak.

It is interesting to note that the forces that caused a slowdown - higher costs, inflation, and interest rates - are now reversing. In other words, the lagging indicators are now declining. But as the cost factors decline, the profit margins tend to improve again. At the same time, since the Fed has now achieved its purpose of controlling inflation, it will start easing again and let the growth of the money supply expand. The jogger is now rested and ready to run at a faster pace.

Now the Fed decides to provide more liquidity because it has achieved its purpose. More liquidity, lower costs, lower inflation, increasing profitability - now the economy is back in a position to start all over again. The jogger has rested and has the strength to start running at a faster pace and the economy is ready to start all over again with phase one. The dollar, reflecting an improved mood, begins to strengthen.

The developments that take place in phase four can be summarized as follows:
• The growth of the money supply continues to decline and as soon as short-term interest rates peak, it begins to rise again.
• The dollar declines and eventually strengthens.
• The stock market remains weak and eventually strengthens.
• The growth of the economy, as measured by the growth of production, sales, income, and employment continues to slow down.
• Profits continue to remain weak.
• Commodities are weak.
• Short-term interest rates decline.
• Long-term interest rates decline.
• Inflation declines.

(From Chapter 4 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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