- The business cycle has a significant impact on the stock and bond markets.
- Determining the current state of the business cycle is harder than some analysts suggest.
- Using the business cycle as an input for managing your portfolio’s stock-bond asset mix can lower risk and increase returns.
The “business cycle” refers to fluctuations in the overall economy. These fluctuations are referred to as a “cycle” because the economy tends to rise above and fall below its long-term growth trend in a cyclical pattern, which can be illustrated as follows.
The Four Stages of the Business Cycle.
- Trough: The economy is in recession. The economy contracts and short-term GDP changes are negative. Corporate profits slump and credit is tight. The central bank lowers interest rates with the goal of stimulating a recovery.
- Expansion: The economy starts to recover. GDP grows at a rate that is in line with its long-term average. Corporate profits begin to rise along with economic activity. The Federal Reserve begins to raise interest rates
- Peak: GDP growth accelerates. Inflation picks up. Monetary policy tightens, pushing interest rates higher.
- Contraction: Economic growth continues but the rate of growth slows. The central bank adopts a neutral policy towards interest rates.
The business cycle is believed to provide insights as to the direction of the stock and bond markets because drivers of both equity and fixed-income prices will often correspond to the current phase of the business cycle. Here’s an idealized summary of how a markets-oriented view of the business cycle tends to unfold.
- Trough: Market gurus yell “SELL, SELL, SELL”, citing poor corporate earnings. Bond prices rise as falling interest rates lead to a search for yield. Ultra-safe investments such as cash, long-term Treasuries and perceived safe havens like gold come into favor.
- Expansion: Stocks begin to rise from their lows during the recession, as the outlook for corporate earnings improves, and market participants begin to pull money out of ultra-safe investments. Gradually rising interest rates put a drag on bond prices.
- Peak: Corporate earnings and stock prices soar while bond prices fall as yields struggle to keep pace with the inflation rate. CNBC’s talking heads scream “BUY, BUY, BUY” and the audience tends to listen, not wanting to miss out on the seemingly easy profits.
- Contraction: Stocks begin to decline and bond prices rise as investors begin to favor safety over growth once again.
By now you might be thinking: “Hey, this is great stuff, Mr. Market Commentator! All I need to do is tailor my portfolio allocations to the current state of the business cycle and I’ll be rich!” If only it were that easy.
Where the Heck Am I?
The business cycle reminds me of a road trip with my college buddies. I was never entirely sure where I was, and was even less certain how long I would be there.
Economists have been trying to calculate the precise stage of the business cycle for centuries with limited success. That’s because there are an almost unlimited number of economic, political, circumstantial, and behavioral factors that affect its course, not all of which are capable of prediction. As a result, it is nearly impossible to know with a high degree of certainty what stage of the cycle the economy is at, and even harder to know how long it will be there.
This Time is Different.
Back in my college days, no two road trips were ever the same. The same can be said about the business cycle. Each cycle is somewhat different, and stock and bond prices don’t always perform as the business cycle would predict, in part because investors are making changes to their portfolio as economic data is published. As a result, trying to follow the business cycle too closely can lead to a bad trip.
These reasons and more have caused some to conclude that trying to predict the direction of the stock market is impossible. Ben Carlson (who writes a great financial blog), recently wrote:
“But the point is losses in the stock market are nothing new. And trying to guess their timing or magnitude in advance is a fool’s game. Knowing what we know today doesn’t help predict what’s going to happen next.”
While for the most part I agree with Ben’s point of view, I also believe that a careful examination of a broad set of economic and financial data can provide useful insight on the current state of the U.S. economy. For example, take a look at The Chicago Federal Reserve Bank’s National Activity Index (CFNAI). It is a free monthly index comprised of 85 economic indicators that is designed to indicate the current level of national economic activity. Even better (in my humble opinion) is The Capital Spectator’s U.S Business Cycle Risk Report, a subscription-only weekly newsletter that evaluates current recession risk for the U.S. economy (you can subscribe HERE).
At the same time, I disagree with those who recommend micromanaging portfolios according to business cycle predictions. Making sector bets based on estimates of where we are in the business cycle, for example, goes too far in my view. Rather, my preference is to use business cycle data to influence target allocations to stocks and bonds generally, and to use other rules-based strategies to break those broad asset class allocations down into individual, passively managed index ETFs.
In short, investors continue to search for a simple, fail-safe signal for the stock market’s future. Some believe the business cycle can be the fortune-teller that they are looking for. I’m not so sure. Just like Tom Hank’s character in the movie “Big”, investors need to be careful what they wish for.