UNDERSTANDING BUSSINESS CYCLE COMPONENTS
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Understanding the 4-Year Business Cycle
The 4-year business cycle has consistently repeated itself since the beginning of the 19th century, when reliable statistics first became available. A typical cycle averages closer to 3.6 years in length and encompasses an economic expansion and contraction. The contractionary phase normally takes the form of a decline in the level of economic activity; i.e., a recession, but sometimes is limited to a slowdown in the rate of growth, known as a growth recession.
When an expansion is particularly long, say six to ten years, it usually includes a growth recession where the economy pauses for breath, but doesn’t actually contract. For example, the recovery that began in 1982 experienced a sharp slowdown in growth in 1984 and 1985. These "double" cycles are also associated with two complete "mini" stock and commodity cycles.
This is an important point because the primary trend of the financial markets: bonds, stocks, and commodities, are determined by the business cycle.
Figure 1 shows an idealized business cycle. The sine curve represents the path of economic growth or contraction, while the horizontal line separates expansionary periods from those of contraction. History shows an economy undergoes a chronological sequence of events during a complete cycle, making it possible to identify turning points for various financial and economic indicators, as well as bonds, stocks and commodities. Figure 1 also shows these idealized juncture points for the three financial markets.
The six stages of the business cycle can be identified. Stage 1 occurs when interest rates peak out; i.e., debt prices turn bullish, but stocks and commodities are still declining. Stage 2 is signaled when stocks join bonds in the bullish camp and Stage 3 when all three markets are in uptrends. You can make more intelligent asset allocation decisions when the prevailing stage of the cycle has been correctly identified. The chronological sequence has worked very well (with a few exceptions) over the last two-hundred years. However, the leads and lags between these various events do alter considerably from cycle to cycle. Also varying is the magnitude of price moves by specific markets.
We use two techniques to identify the various stages. The first is a very simple technical approach of comparing each market with its 12-month moving average. The proxies we use are long-term government bond prices, the S&P Composite, and the CRB Raw Industrial Commodity Index. We use raw industrial prices because they better reflect changing conditions in the business cycle. Inclusion of grains and other weather driven commodities only serves to distort the overall picture. Therefore, eliminate weather as a factor.
When a market is above its average it’s considered to be bullish and vice versa. There is no moving average time span that can be expected to work perfectly over all markets at all times though. The 12-month span, however, seems to test better than most. Even so, this approach does trigger quite a few whipsaw signals. That’s why we rely on a more rugged test of a market’s primary direction. For this purpose, we have created a Barometer for each market.
A Barometer is a collection of economic, financial and technical indicators. Each one has a good track record of identifying bull and bear market environments for a specific market. None of these indicators are perfect, but when they are combined within the Barometer, a consensus of 51% or more of bullish components triggers a buy signal for the market in question.
Even the Barometers have weak periods, but by and large, their use, along with the 12-month moving average test, works reasonably well. The table above shows how the Barometers performed in the 1980’s and 1990’s. You can see that by and large they experienced an accurate chronological sequence as the environment swings through the various stages. Occasionally a stage is skipped, such as Stage I and Stage VI in 1989, and Stage I in 1995. Also, the Barometers have been known to retrograde as they did in mid 1993 by moving back from Stage III to Stage II and then on through Stage III again.
The varying lengths of each stage is also apparent from this table. Stage II, in 1985-86, for example, was particularly lengthy. However, in 1990 it was very short. It is important to note that the barometers just paint a bullish or bearish environment for a specific market. The market itself will usually respond to that environment in the expected way, but that is not always the case. This is why they do not usually catch the turning points of markets as close as we would like. This is especially true of the stock market. The 1995 buy signal, for instance, developed well after the December 1994 low. While specific Barometers may fail from time to time for a specific cycle, this approach works very well over the long term.
Table 2 highlights the average annualized monthly total return for each asset category for each stage of the cycle (as defined by the Barometers). For example, bonds in Stage 1 have gained 28.6% in the seven defined cycles since the early 1950’s, whereas Stage 4, when they first turn bearish, have averaged a loss of 7.3%. Stocks have gains of 24.8% in Stage 2 and a loss of 12.4% in stage 6. In Stage 3, when both stocks ties have earned 20.1% compared to a relatively small average 9.6% for bonds. Stage analysis is useful both to assess whether returns will be positive or negative and as a guide to which asset class is likely to put in the best relative performance.
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