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Financial Markets and Business Cycle

It is important to understand that primary trends of stocks, bonds, and commodities are determined by the attitude of investors during unfolding of events in the business cycle. An understanding of the interrelationship of credit, equity, and commodity markets provides a useful framework for identifying major reversals in each.

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Market Movements and the Business Cycle

  • The bond market is the first financial market to begin a bull phase. This usually occurs after the growth rate in the economy has slowed down considerably from its peak rate, and quite often is delayed until the initial stages of the recession. Generally speaking, the sharper the economic contraction, the greater the potential for a rise in bond prices will be (i.e., a fall in interest rates). Alternatively, the stronger the period of expansion, the smaller the amount of economic and financial slack, and the greater the potential for a decline in bond prices (and a rise in interest rates).
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  • Following the bear market low in bond prices, economic activity be gins to contract more sharply. At this point, participants in the equity market are able to “look through” the trend of deterioration in corporate profits, which are now declining sharply because of the recession, and to be gin accumulating stocks. Generally speaking, the longer the lead between the low in bonds and that of stocks, the greater the potential for the stock market to rally. This is because the lag implies a particularly deep recession in which extreme corporate belt tightening is able to drop breakeven levels to a very low level. During the recovery, increases in revenue are therefore able to quickly move to the bottom line.
  • After the recovery has been under way for some time, capacity starts to tighten, resource­ based companies feel some pricing power return, and commodity prices bottom. Occasionally, after a commodity boom of unusual magnitude, industrial commodity prices bottom out during the recession as a result of severe margin liquidation due to excessive speculation during the previous boom.
  • However, this low is often subsequently tested, with a sustainable rally only beginning after the recovery has been under way for a few months. At this point, all three financial markets are in a rising trend.
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  • Gradually, the economic and financial slack that developed as a result of the recession is substantially absorbed, putting upward pressure on the price of credit, i.e., interest rates. Since rising interest rates mean falling bond prices, the bond market peaks out and begins its bear phase. Because some excess plant and labor capacity still exists, rising business activity results in improved productivity and a continued positive outlook. The stock market discounts trends in corporate profits, so it remains in an uptrend until investors sense that the economy is becoming overheated and the potential for an improvement in profits is very low. At this point, there is less reason to hold equities, and they, in turn, enter into a bear phase.
  • Later on, the rise in interest rates takes its toll on the economy, and commodity prices begin to slip. Once this juncture has been reached, all three financial markets begin to fall. They will continue to decline until the credit markets bottom. This final stage, which develops around the same time as the beginning of the recession, is usually associated with a free­-fall in prices in at least one of the financial markets. If a panic is to develop, this is one of the most likely points for it to take place.

In any event, the “economy” consists of a host of individual sectors, many of which are operating in different directions at the same time. Thus, at the beginning of the business cycle, leading economic indicators, such as housing starts, might be rising, while lagging indicators, such as capital spending, could be falling.

Since housing leads the economy, housing stocks do well at the start of the recovery, when capital­ intensive stocks such as steels tend to under-perform. Later in the cycle, the tables are turned and housing peaks first, usually in an absolute sense.

Since the financial markets lead the economy, it follows that the greatest profits can be made just before the point of maximum economic distortion, or disequilibrium. Once investors realize that an economy is changing direction and returning toward the equilibrium level, they discount this development by buying or selling the appropriate asset. Obviously, the more dislocated and volatile an economy becomes, the greater is the potential, not only for a return toward the equilibrium level, but also for a strong swing well beyond it to the other extreme. Under such conditions, the possibilities for making money in financial markets are greater because they, too, will normally become subject to wider price fluctuations. Two of the wildest post–World War II economic swings (1973–1974 and 2007–2008) certainly provided traders and investors with a roller coaster ride, with great profit possibilities were they able to identify the two respective bear market lows.

Periods of expansion generally last longer than periods of contraction because it takes longer to build something up than to tear it down. For this reason, bull markets for equities generally last longer than bear markets do.


THE SIX STAGES

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Since there are three financial markets and each has two turning points, it follows that there are conceptually six turning points in a typical cycle. The six stages can be used as reference points for determining the current phase of the cycle.

When identifying a stage, it is important to look at the long ­term technical position of all three markets so they can act as a cross­check on each other. The stages are also useful, in that specific industry groups outperform the market at particular times and vice versa. For example, defensive and liquidity ­driven early ­cycle leaders tend to do well in Stages I and II. On the other hand, earnings ­driven or late­ cycle leaders perform well in Stages IV and V when commodity prices are rallying. These aspects will be covered in another post on sector rotation.


CONCLUSION

  • A typical business cycle embraces three individual cycles for interest rates, equities, and commodities. All are influenced by the same economic and financial forces, but each responds differently.
  • These markets undergo a chronological sequence that repeats in most cycles.
  • Some cycles experience a slowdown in the growth rate and not an actual recession.
  • Even so, the chronological sequence between markets still appears to operate.
  • The leads and lags vary from cycle to cycle and have little forecasting value.
  • The chronological sequence of peaks and troughs in the various financial markets can be used as a framework for identifying the position of a specific market within its bull or bear cycle.

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Thank you for reading.
By
Animesh Vashisht
Mob. +917906818121 (Whatsapp to be part of my broadcast list)

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