The central bank and your investments: Financial Cycles

The amount of money made available by the Fed is the main driver of the economy and the financial markets. Changes in the growth of money create huge waves, lasting about five years, that have a big impact on our lives and on the price of most assets. From mid 1955 to 1995 there have been seven major financial cycles, and each cycle started with the money supply accelerating rapidly from a low level close to 0.3% in a weak economic environment. Growth in monetary aggregates in a typical financial cycle has risen to 10-15%, to decline again to about 0-3%. A complete cycle includes two consecutive troughs and this period of time usually spans about five years.

The stock market performs well during the first half of the financial cycle, when growth in liquidity increases. However, stocks perform poorly in the second half of a financial cycle when liquidity slows down. The stock market closely follows changes in liquidity because its strength or weakness depends on how much money there is in the system. If money grows rapidly, some of it is invested in the economy by business and consumers and some is invested in stocks, and stocks rise. However, when liquidity slows down, stocks decline as investors sell stocks to raise money to be used for other purposes.

The eighth financial cycle began early in 1995 with the growth in MZM close to 0%. The first half of the cycle ended in March 1999 when the growth of most monetary aggregates peaked and MZM was expanding at a rate of about 15%. Most measures of money supply slowed down in 1999 and, not surprisingly, the overall market became much more erratic with a very large number of stocks forming major peaks. Broad market averages, such as the S&P 500, showed no change from March 1999 to March 2000. The stock market does not perform well in the second half of a financial cycle, and the eighth financial cycle since 1955 was no exception. The growth in monetary aggregates, which is a measure of liquidity provided by the Fed to the system, can be used to assess what is happening and what is likely to happen to the business cycle and the financial markets (Fig. 6-3). A financial cycle goes through four distinctive phases.

In phase one of a financial cycle, liquidity accelerates, accompanied by a strong stock market. In the meantime the economy grows slowly, commodities are weak, and short-term and long-term interest rates decline. It is quite typical for the dollar to strengthen during this phase in anticipation of strong economy and lower inflation. In phase two, the economy begins to pick up its pace and grows more rapidly. Commodities and short-term and long-term interest rates bottom. The stock market continues to rise. The dollar remains strong.

In phase three, the growth in monetary aggregates declines while the economy remains strong. Interest rates and commodities keep rising as the dollar sputters. Stocks begin to perform poorly. This is a critical phase for the stock market because it becomes much more selective. Investors should recognize that risk is at the highest level, and their investment strategy should become much more defensive. Short-term interest rates typically rise at least two percentage points (200 basis points) during phase three of a financial cycle.

In phase four, the protracted decline in liquidity and the sharp rise in interest rates which occurred in phase three cause the economy to slow down quite visibly. As the economy begins to grow slowly, interest rates and commodities peak and then decline. By this time the growth in monetary aggregates is very slow, close to 0-3%. The stock market bottoms as the dollar rises. The decline in interest rates stimulates new borrowing and a new phase one is under way again.

The cyclical turning points in short-term interest rates (rates on 13-week Treasury bills) coincide with important turning points in commodities, such as crude oil. They are both dependent on the strength of the economy and by previous expansion on monetary aggregates. This implies a limited lack of control the Fed has on interest rate trends.

Financial cycles are closely related to major crises. The real estate crisis of 1992-93, the Asian crisis in 1997, and the Latin America and Russia crisis in 1998 were all accompanied by aggressive easing by the Federal Reserve and by the strong growth in the money supply. The main reason, of course, is the concern of the Federal Reserve that a financial crisis of major proportions would affect in a negative way the banking system, and as a result, the rest of the country or the global economy. For this reason, it becomes a priority to provide liquidity to the banking system in the U.S. and global banks, in conjunction with central banks of other countries, so that a smooth operation of the economy could be maintained. Because of the strong relationship that exists between growth in the money supply and growth in stock prices, it is not unusual to see financial crises accompanied by a strong stock market. The main reason is that the aggressive injection of liquidity in the banking system spills over in the financial markets, thus placing upward pressure on stock prices. It is exactly what happened in 1992-93, in 1997 and 1998.

(From Chapter 6 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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