Part II : Asset Building Through Equity

Part  II :   Asset  Building  Through  Equity

CHAPTER 9: BUSINESS CYCLE AND STOCKMARKET

“THE UNSEEN FORCE THAT MOVES THE MARKET”

The wise never undertake an enterprise

Which rashly risks existing capital to reach for potential profits.   

                                                                                                     THIRUKKURAL   Verse 463

INTRODUCTION:

Business cycles started with industrialization. They are not regular and are not all alike. They are not identical twins, but they are recognizable as belonging to the same family. Each cycle has different lengths and the turning points are hard to predict.

The financial markets and the real economy interact between themselves and in doing so they display cause and effect relationships. The outcome is business and financial cycles which last for about 5 to 7 years.

Modern Business Cycle:

Paul.A.Samuelson has described a modern business cycle as follows: “Business conditions never stand still. Prosperity is followed by a panic or crash. National income, employment and production fall. Prices and profits decline and men are thrown out of work. Eventually the bottom is reached, and revival begins. The recovery may be slow or fast. It may be incomplete, or it may be so strong so as to lead to a new boom. The new prosperity may represent a long sustained plateau of brisk demand, plentiful jobs, buoyant prices, and increased living standards. Or it may represent a quick, inflationary flaring up of prices and speculation, to be followed by another disastrous slump”.

When cycles are unusually long, it is the depression, rather than the prosperity, that is long.

ECONOMIC INDICATORS:

Economic indicators are useful in understanding business cycles.

The great majority of economic indicators fall into one of the following three categories: leading, coincident, and lagging indicators.

The basic thread tying together all the indicators is their lead-lag relationship and the important feedbacks which keep the system under control. These features make the prices move between extremes (over bought and over sold), creating investment opportunities.   The reason is that they are quite reliable in anticipating changes in the economy and the financial markets.

Important turning points in the growth of the money supply lead to turning points in the growth of the economy.

For a period extending to over 100 years, ‘The National Bureau of Economic Research’ (N.B.E.R.), New York, has established 26 Business Cycle indicators for the US economy. To mention a few below:

Leading  Indicators:

1.  Average work week, manufacturing

2.  Gross accession rate, manufacturing

3.  Housing starts

4.  Number of new incorporations

5.  Corporate profits after taxes

6.  Stock market price index of common stock

7.  Industrial raw materials, spot market price index

Coincident Indicators:

1.  Employment in non-agricultural establishments 

2.  Unemployment rate

3.  Total industrial production index

4.  Gross National Product

5.  Personal income

6.  Wholesale price index excluding form products

Lagging Indicators:

1.  Plant and equipment expenditure, total

2. Wage and salary cost per unit of output, 

    Manufacturing

3. Consumer installment debt

4. Bank interest rates

The leading indicators provide a clue to the future of economy. Their behavior has forecasting significance. A forecast may be made on their performance and subsequently confirmed by the performance of the other indicators. The ideal indicator does not exist. If it did, then the other indicators would be superfluous.

Monitoring over the decades has proved that the leading indicators have performed remarkably well. In particular the stock market price index has been found equally dependable.  

Business Cycle & Stock Performance

Why is this analysis crucial for the investor? The answer is that it tells you about the level of risk in the stock market and about alternative investment opportunities. It provides you with a blueprint of how to manage your investments. As new information becomes available you know the position of the stock market relative to the economy and other markets. But what is even more important for the investors is the understanding of knowledge of the relationship existing between them to know what is to expect.

ECONOMIC CYCLE AND STOCK CYCLE

The above chart shows a typical business cycle and the points at which various economic sectors tend to outperform the broader market. The chart is a historical representation of stock performance movements relative to the business cycle and is not intended to convey any current or future economic outlook.

Conclusion:

“The 28 year record of Indian Stock market (1938 to 1966) shows that the Indian Stock Market price index is cyclical – that is, it has distinct crests and troughs, separated by long intervals of time”.                                                       Business Forecasting – G.R.Mansukhani

The trend of stock price index has been a subject of research for the past many decades. Dependable and reliable method of determining the trend has been evolved. The basic principles for determining stock trends were laid down by Charles H.Dow around 1900; popularly known as Dow Theory. Let us have an insight on Dow Theory in the next chapter.

Dr.Felisleo

26.12.2010