As we expand our analysis of the behavior of economic and financial indicators, it should become increasingly clear that all of these gauges are closely related to each other. They all help to understand how business and financial cycles go through their different stages. It is also helpful if readers remind themselves that all of these indicators discussed belong to one of three categories.

The overwhelming majority of economic and financial indicators are either leading indicators, coincident indicators, or lagging indicators of the business cycle. It is also important to be aware of the relationship between these three groups of indicators. Once one knows what group an indicator belongs to, it is easy to understand and easy to use it as a tool for forecasting and assessing the risks presented by the financial markets.

In the previous chapter we saw that important financial variables, such as growth in the money supply and short-term interest rates, belong to a specific classification. The growth of the money supply is a leading indicator of the business cycle and short-term interest rates are lagging indicators. We also hinted that stock prices, since they reflect the amount of liquidity in the banking system, are also leading indicators of the business cycle. Inflation is a lagging indicator.

You already have a powerful model tying together these crucial variables. This model allows you to tie together the behavior of the economy, the money supply and short-term interest rates. A rise in the growth of the money supply is followed, after one to two years, by a stronger economy. A stronger economy, characterized by business growth rising above its long-term average, is eventually followed by higher short-term interest rates. The reason, as discussed earlier, is that these are times when there is considerable pressure on resources, such as productive capacity, employment and commodities. As a result, strong demand for credit places upward pressure on short-term interest rates.

After a few months of rising short-term interest rates, the growth of the money supply declines due to the increased cost of credit. This development is followed, after about one to two years, by a slowdown in the economy and eventually by lower short-term interest rates. Lower short-term interest rates are followed after a few months, by rising growth in monetary aggregates, and the cycle starts all over again.

These relationships can best be followed by using the concepts relating peaks and troughs of leading, coincident and lagging indicators. Since the growth of the money supply is a leading indicator, the growth of industrial production is a proxy for economic trends, and the level of short-term interest rates is a lagging indicator, the following lead/lag relationships tie these indicators together.

• A trough in the growth of the money supply is followed by
• A trough in the growth of industrial production, which is followed by
• A trough in short-term interest rates, which is followed by
• A peak in the growth of the money supply, which is followed by
• A peak in the growth of industrial production, which is followed by
• A peak in interest rates, which is followed by
• A trough in the growth of the money supply

And the cycle starts all over again.

In this chapter we will examine the process of inflation in more detail than in chapters two and three. We will look at how inflation is related to the business cycle, how and when it becomes a problem, and what are the conditions that will bring it under control again.

Commodities are important indicators of business cycle development. Their behavior can provide unique information. We will explore when one should expect a rise or decline in commodities and how this change in commodity levels is related to the business cycle and to inflation.

Because of the impact wages have on inflation, we will devote a section on their impact on inflation and on the conditions that cause wages to be inflationary. This issue is important because a tight labor market and rising wages are not necessarily inflationary. The level and trend of inflation also plays a major role on the value of the dollar against other currencies. Of course, this is an important subject because changes in the dollar have a major impact on returns of foreign investments.

Finally, in the last section we will recap the main points of the chapter and examine how they should be used to develop an investment strategy.

(From Chapter 7 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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Adam Jewl said...

Nicely explained the concept of inflation on the investment. I found this very informative and willing to read more chapters. Inflation has a prominent impact on the overall economy. Financial Analysis

www.peterdag.com said...

Thank you.