In the prior sections we reviewed the concept of leading, coincident, and lagging indicators, how they are computed, what they mean and how they can be used. In the previous section we looked at how the business cycle evolves from a period of slow growth, to stronger growth, then slower growth again, going through four distinct phases. As the business cycle moves through these phases, the economic indicators maintain precise relationships, as discussed above. In particular, we have noticed how rising lagging indicators, such as change in unit labor costs, inflation, and interest rates provide crucial information for investors. It warns them to look for a peak in the leading indicators, such as stock prices and changes in the growth of the money supply.
The purpose of this section is to see how the evolving economy creates situations making it necessary to adjust your investment portfolio. We will examine the process from the investor's viewpoint in order to recognize the strategic implications derived from changes in the growth of the economy.
At the beginning of phase one the economy grows very slowly, and as we have seen, the posture of the Fed is let the money supply grow faster in order to accommodate the demand for credit. The increased availability of credit is a measure of the liquidity in the economic system. The money supply accelerates and this increased liquidity has an immediate positive effect on stocks. Profit margins start improving because of the declining cost of money, cost of labor, and raw material prices.
The U. S. dollar, sensing there is an improved tone in the economy, strengthens. This is an important barometer of the health of the economy. The stronger dollar confirms that all the trends in place are likely to continue. Production at this time is still weak and so are commodities. Because of the slack in the economy, the unemployment rate is high, capacity utilization is low, commodities are weak, inflation is declining and short-term interest rates are heading down or are stable, while bond yields decline due to lower inflation.
This is the phase of the business cycle that is most favorable to stocks. Investment in commodities and hard assets are not particularly attractive due to low inflationary pressures. Because of lower inflation, bond yields decline making bonds an attractive investment.
As the economy strengthens in phase one, several developments take place. Initially, they occur gradually but then they become more and more visible. Commodities do not decline as rapidly and eventually stabilize for several months. Then they start gradually rising. The action of commodities is followed closely by short-term interest rates. Bond yields do not decline as rapidly, and eventually they bottom. For instance, in 1994 when the economy strengthened quite visibly, commodities rose quite sharply, accompanied by a rise in interest rates from 3 to 6% and also by sharply rising bond yields.
This gradual change in trend suggests the economy is slowly moving into phase two when growth becomes quite strong. The business cycle moves into phase two when the economy grows beyond potential. Risks are beginning to increase for some assets while others become more attractive. As the economy grows above potential, commodities start growing quite rapidly. Therefore, investments in commodities or industrial types of assets that are commodity driven become attractive.
Inflation bottoms out at the beginning of phase two and the odds favor even higher inflation as resources become more fully utilized. Because of increasing inflation, bond yields bottom and possibly rise. Bonds, as a result, become less attractive. This is the time when risk begins to shift. Investment in stocks becomes riskier because the business cycle is in a strong growth phase with yields too high to justify current price earnings ratio. Commodities also remain an attractive investment. With inflation rising, real estate investments are beginning to offer a good opportunity as prices of real estate reflect the underlying inflation and tend to rise at a faster pace than inflation. Due to rising inflation, bond yields are rising, thus making bonds a high-risk investment.
In phase two, when the economy becomes very strong, the Federal Reserve recognizes that the strong growth in credit is causing the economy to overheat, generating strong inflationary pressures. Therefore, the Fed will attempt to slow down the growth in credit to achieve slower and more sustainable growth in the economy. Two developments usually happen at this time. The money supply slows down, a sign that the liquidity in the system is decreasing. Stocks peak due to slower growth in the money supply as short-term and long-term interest rates continue to rise.
The dollar weakens, as we mentioned above, thus making foreign investments more attractive. Profits decline as costs rise and productivity slows down. The business cycle now moves into phase three with the financial markets at a high-risk level while hard asset investments (energy stocks, gold stocks, commodities, real estate, art, etc.) provide more attractive returns.
In phase three, the leading indicators such as, growth of the money supply, stocks, and profits, decline. The dollar is weak as the economy slows down and tries to readjust. Bond yields keep rising and production slows down and commodities do not rise as rapidly and eventually decline. Inflation is still rising, short-term interest rates continue rising and the Fed is firm in controlling the growth in credit. The Fed will continue this policy until there are signs inflation will decline. Bond yields will eventually follow inflation down.
Phase three is a very unfavorable period for financial instruments and is more favorable for hard assets. Eventually, the economy enters phase four. The economy is slow, the Federal Reserve has finally achieved its objective of slowing down the economy below potential, and investors begin to see signs that inflation is declining. Phase four is a very important phase because all of the indicators that created a slowdown are now reversing themselves and create new investment opportunities. Inflation peaks and starts declining. Bond yields peak, wages slow down, and costs decline. Bonds offer good investment opportunities at this time. The Federal Reserve recognizes that inflation has been brought under control and the economy is likely to stabilize.
Low inflation and lower bond yields make stocks attractive again. Short-term interest rates decline because now the Fed is gradually easing and the financial instruments become attractive again. Commodities are weak, inflation declines, short-term rates and bond yields continue to head downward. The dollar finally improves as the excess generated in phase two and three are brought under control.
The Fed recognizes business conditions are normal again and allows liquidity to increase. The business cycle is close to entering phase one with all the financial markets in an uptrend.
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.
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.
The important developments that take place in phase three are the following:
• The growth of the money supply continues to decline.
• The dollar is 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 continue to rise and eventually decline.
• Inflation continues to rise and eventually decline.
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.
The rest of this book will examine in more detail the various aspects of the financial markets and we will discuss which indicators are most suitable to assess the risk and predict the trend of each asset.
First, however, we must deal with a very important issue and that is to examine the important changes in the economy in the financial markets that took place since 1955. Why did these changes take place? What can we learn from them? How can we use the lesson of history to protect your portfolio? What happened after 1955 has an invaluable and profound impact on how to establish a long-term investment strategy. This is the subject of the next chapter.
(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.
2009 Market Timer of the Year by Timer Digest
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