The Financial Philosopher: Understanding Cycles Part 2: Stocks & The Economy

"The stock market has predicted eight of the last five recessions." ~ Paul Samuelson

The stock market is considered a "leading economic indicator," which means that the general direction of stock prices (up or down) indicates the future direction of the economy. The problem is that the stock market also gives many "false signals." I'll address this "problem" later in the post...

The primary reason that stock prices are a leading indicator is because of "discounting," which is essentially a means of pricing the value of stocks today based upon their expected value in the future. If stock analysts, money managers, and other investors are "betting" that the economy will go into recession, selling will increase and stock prices will fall. Conversely, they will bid prices higher if the opposite expectations are held. Once again, the problem is that even the most seasoned of investors are not always correct in their expectations. This is why short-term forecasting is extremely difficult and not recommended...

This post is not about "timing the market" as in jumping from stocks to cash and from cash to stocks but about managing risk. If we understand history, then we can make certain assumptions about where stocks and the economy will be in the future -- not six months into the future -- but thirty-six months into the future -- and, accordingly, make small periodic adjustments to our portfolio, depending on where we are in the cycle...

First, let's gain a simplified understanding of the business, or "economic," cycle. Put simply, the business cycle is a period of up and down movements in economic activity, as measured by Gross Domestic Product(GDP), which is a measure of "the market value of all goods and services" in our country. A positive GDP indicates the economy is expanding, or growing, and a negative GDP indicates the economy is contracting, or receding. Two quarters of negative GDP is considered a "recession." A full or complete cycle would include an economic "high" or peak and an economic "low" or trough, and the duration is typically measured from "peak to peak." A visual would be helpful here:

While reading the following stats, check back to the chart. It will help you with the remainder of the post:

From 1854 to 2001 there were 32 cycles with the average (peak to peak) being 56 months.
The average cycle from trough to peak (bottom to top) was 38 months.
The longest cycle in duration, peaking March 2001, was 128 months.
The shortest cycle was 17 months, peaking January 1920.
The current cycle, measured from the previous peak in March 2001, is over 80 months in duration, making it the fourth longest (out of 32 cycles) since 1854.

Because even the most seasoned traders and money managers can not forecast future economic and market movements, the long-term investor, who wishes to engage in active management of their portfolio, will focus on longer-term averages and avoid the lure of short-term "noise."

For myself and my clients, I prefer "risk management" to "market timing." My usage of cycles is simply to stay cognizant of the current cycle's duration so I can make a better assessment of risk exposure. For example, when it is widely known that the U.S. economy is in "recession," then the long-term investor can begin to take more risk, based on the averages, because a recession and corresponding Bear market are not likely to occur within the following 36 months (remember: the average cycle's trough to peak is 38 months). Using the current business cycle as an example, as of December 2007, we're over 80 months into the cycle from the last peak in March of 2001; therefore, based on history, the risk is now greater that stock prices will decline significantly in the next 36 months; and we "manage risk" prudently by gradually reducing exposure to riskier areas of the market until it is apparent that full recession is upon us... Then we may gradually increase risk again...

As TFP readers are well aware, I favor this graphic for understanding the relationship between the economic cycle and the stock market cycle:

As you can see, the stock market cycle peaks before the economic cycle. As I previously stated, based on the averages, it is much more likely that a Bear Market and Recession will occur in the next 36 months than not; therefore, the long-term investor can reduce risk (under-weight small-cap stocks, emerging market stocks and over-weight large cap stocks, bonds, defensive stock).

Of course, I should caveat this entire post by reminding readers that a long-term portfolio should first reflect the individual investor's objectives (time horizon, investment goal), risk tolerance, and risk capacity. Then, the asset allocation is formed. If economic and market cycles are observed, and a part of the allocation strategy, then any resulting investment decisions are secondary...

I will summarize my thoughts on cycles in the third and final installment into this series of posts next week. In the mean time, feel free to peruse the first installment, Understanding Cycles Part 1: Investments and Emotions.

TFPAuthor, Kent N. Thune, QPFC, is the President and founder of Atlantic Capital Investments, LLC (ACI), a 'fee-only' Registered Investment Advisory firm located in Mount Pleasant, SC.