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The Business Cycle

The Business Cycle
Certain sectors of business profit more in certain stages of the economic cycle. This cycle can provide a road map to traders as to how to trade each sector during each phase of the cycle.  Tonight we will take a look at this and see how we can profit from the business cycle and sector rotations.  Sector rotation is an investment strategy that involves moving money from one industry sector to another during the various stages of the business cycle.  A business cycle is the recurring and fluctuating levels of economic activity that an economy experiences over a long period of time. The five stages of the business cycle are: expansion peak recession and recovery. At one time business cycles had very predictable durations but now business cycles are irregular varying in frequency magnitude and duration. 

A recession is a significant decline in activity across the economy. A recession generally lasts from 6 to 18 months and by no coincidence is how long Bear markets generally last.  A recession is visible in industrial production employment income and wholesaleretail trade. The first sign of a recession is two consecutive quarters of negative economic growth as measured by our Goss Domestic Product.  Since 1945 the U.S. economy has experienced 11 recessions and 10 expansions.  We are currently in the 11th expansion but if Greeny keeps raising rates we may be approaching our 12th recession soon.  

There are statistics that show when expansions are divided into early middle and late phases of equal durations and when recessions divided into early and late periods of similar lengths.  With a recession a pattern of sector rotation and stock performance is apparent.  It is important to remember that the past performance of stocks does not always mean future success following this cycle.  A particular sector may or may not be in favor at any time due to outlying factors. However we have a road map of past performance and we can look at what has worked for stocks in the past. 

Four Stages of the Stock Market Cycle
The stock market moves up and down with the economy.  The four stages of the stock market cycle are: 

1) Market Bottom This is represented by falling stock prices culminating in a longterm low. 

2) Bull Market This begins as the market rallies from the market bottom. 

3) Market Top In this stage the market reaches a climatic top and the bull market starts to flatten out. 

4) Bear market We all know what this means stocks start to decline in price and continue declining for months.  This brutal slow bleeding keeps people in hoping for a turn around.  This turn around may not come until after they just cannot take it anymore and sell the last of their stocks in a climatic capitulation sell off.  The bear takes a generation of new investors to the cleaners wiping them out of the market for years if not forever.  It is only then that the market bottom comes and the cycle begins all over again.  

We know the stock market attempts to predict the state of the economy 3 to 6 months into the future. That means that the stock market cycle is usually well ahead of the economic cycle. This is crucial to remember because as the economy is in recession the stock market begins to look ahead to a recovery and vice versa; when the economy is peaking at the end of a business expansion the stock market starts to decline. We may be seeing this soon if the Federal Reserve keeps raising rates to slow down the economy. 

Four Stages of the Economic Cycle
There are four basic stages of the economic cycle with some associated signals.  Keep in mind that these usually trail the stock market cycle by a few months. 

 Full Recession This is not a good time for businesses or the unemployed.  GDP has been retracting quarteroverquarter interest rates are falling consumer expectations have bottomed and the yield curve is normal. Sectors that have historically profited most in this stage include: Cyclicals and Transports Technology and Industrials (near the end). 

 Early Recovery This is when things are starting to pick up.  Consumer expectations rise industrial production is growing interest rates have bottomed and the yield curve is beginning to get steeper. Historically successful sectors at this stage include: Industrials (near the beginning) Basic materials industry and Energy (near the end). 

 Late Recovery In this stage interest rates can be rising rapidly with a flattening yield curve. Consumer expectations are beginning to decline and industrial production is flat. Here are the historically profitable sectors in this stage: Energy (near the beginning) Staples and Services (near the end). 

 Early Recession This is where things start to go bad for the overall economy. Consumer expectations are at their worst; industrial production is falling; interest rates are at their highest;

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