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The Business Cycle Phases

Investors who beat the market recognize that business cycle phases are the primary determinant of stock prices.

Business Cycle Phases

The business cycle phases define long-term pattern of changes in Gross Domestic Product (GDP) that  follows four basic stages: expansion, prosperity, contraction, and recession. After a recessionary phase, the expansionary phase starts again.

The business cycle phases are characterized by changing employment, industrial productivity, and interest rates. Stock analysts believe that stock prices lead the business cycle phases. This economic cycle provides the strategic framework for business activity and investing. Moreover, the business cycle phases affect employees, employers and investors.

For example:

When the business cycle doesn't run as expected, it can have consequences that can be as disastrous as the Great Depression. That's why governments intervene to try to manage the economy. If it appears that inflation is rising too quickly, the Federal Reserve (the central bank of the U.S. charged with handling monetary policy) may decide to raise interest rates to curtail price increases. On the other hand, if the economy is performing poorly, the government may lower taxes to spur consumption and investment and the Federal Reserve may lower interest rates to reduce the cost of borrowing.

Interest rates and the yield curve play a very important role in determining economic activity, the phases of the business cycle and the performance of the stock market. Higher interest rates increase the costs to businesses and individuals. Companies must pay more to borrow money for capital investments or to fund daily business operations. Individuals pay more for mortgages, as well as other loans they may take out to purchase products. Higher interest rates also increase the demand for money to invest in bonds, competing for money to invest in the stock market.

The phases of the business cycle have implications for markets and investors. Broadly, a recession often corresponds with a sustained period of weak stock prices, or a bear market. And a healthy, expanding economy that keeps inflation from rising too quickly often corresponds with a bull market, or period of sustained market growth.

Sector Rotation

Fortunately, there are investment strategies for each phase of the business cycle. Sam Stovall's Sector Investing, 1996 states that different sectors are stronger at different business cycle phases. The table below describes this theoretical model showing the phases of the business cycle.

Phase:
Consumer Expectations:
Industrial Production:
Interest Rates:
Yield Curve:
Full Recession 
Reviving
Bottoming Out
Falling
Normal
Early Recovery 
Rising
Rising
Bottoming Out
Normal (Steep)
Full Recovery 
Declining
Flat
Rising Rapidly (Fed)
Flattening Out
Early Recession 
Falling Sharply
Falling
Peaking
Flat/Inverted

The graph below, courtesy of StockCharts.com, shows these relationships and the alignment of the key sectors as they respond to the business cycle. The stock market cycle tends to precede the business cycle by six months on average, as investors try to anticipate when the market will respond to changes in the economy. This means investors are more likely to beat the market, if they invest in the sectors that line up with the current and next phase of the business cycle.

Sector Rotation Model:


Legend:  Market Cycle
              Economic Cycle

As shown above the stock market is a leading indicator of the economic or phases of the business cycle. Since the market leads the economy, investors need to pay particular attention to the early signs of a change in each phase of the business cycle.

Many people believe that GDP is the primary indicator of the business cycle. The National Bureau of Economic Research (NBER) gives relatively low weight to GDP as a primary business cycle indicator, since the GDP is subject to frequent revisions after the fact. In addition, it is only reported on a quarterly basis. The NBER is the official organization that defines when the U.S. is in a recession and when it comes out of one.

The NBER relies on indicators that are reported monthly to identify the business cycle phases including:

By following these indicators carefully, investors can anticipate when to expect changes in the business cycle. These indicators tend to change their trajectory over several months, giving investors ample time to identify a change in the trend. If you believe a change in the phase of the business cycle is underway then it is time to  close out sectors that will go out of favor and start new positions in sectors that will come into favor. This strategy will position you to beat the market using the phases of the business cycle as a guide.

Our stock market strategy begins with an understanding of where we are in the the business cycle. Assessing the business cycle phases is the first of five steps in our stock market strategy that we use to beat the market.

  1. The Business Cycle Phases
  2. Stock Market Trend Analysis
  3. Stock Selection Guide
  4. Disciplined Investing
  5. Stock Portfolio Management

Our Premier Members are aware the business cycle phase the economy is operating. This insight provides a critical component we use to align our portfolio with the business sectors that will outperform the market in the coming months and years.

The next step on how to Beat the Market discusses how to identify the important trends in the market. Please read Stock Market Trends.