Understanding Business Cycles

It’s critical to your investment success to understand business cycles and how they affect the economy, businesses and investments.
Most Western economies have traditionally gone through swings in economic activity. On a very superficial level you may remember the swing high as times when employment is very strong, businesses are reporting record profits and money seems to be everywhere like around the year 2000 in the tech boom. And you may remember the lows as in the early 1980’s when bankruptcies, layoffs and interest rates were at record highs.
In fact the business cycle is more specific than that. It is made up of four major sections: peak, recession, trough and recovery (which leads back to a peak again).
From an investing point of view you want to invest (a buy position) in the troughs and sell at the peaks. Many people don’t know this but it is possible to make money on the way up to the peak and on the slide down the other side. How you make money on the way down is by using a technique called selling short (or shorting a stock). When you do this you sell it before you
buy it. Sounds confusing? In reality you are borrowing the funds from your discount broker to sell it first. Then as it continues its way down in value you buy it back at a lower value. Remember the golden rule of investing – buy low, sell high? Well that is exactly what you are doing when you short a stock on the way down. Many shrewd investors made millions on Nortel over the last few years as it made its spectacular decent. They did it by selling short. You can do the same.So how do you identify the peaks, recessions, troughs and recoveries? Here are some of the things you should look at to determine the phase of the business cycle that you are in:
The Peak
Profits: reaching a maximum
Savings: decreasing
Spending: increasing
Output/Production: increasing
Employment: steady or increasing toward full employment
Bankruptcies: low
Other: Output is greater than sales, profit margins become thinner, inventories rise

The Recesion
This is a period of two or more consecutive quarters where there is decline in output, employment and income.
Profits: declining
Savings: increasing
Spending: decreasing
Output/Production: decreasing
Employment: decreasing
Bankruptcies: increasing
Other: production capacity is greater than sales potential, reducing output (which also decreases employment) helps companies manage the high inventory levels.

The Trough
This is where output and employment reach their lowest levels.
Profits: low
Savings: high
Spending: low
Output/Production: lowest point
Employment: unemployment reaches high point
Bankruptcies: reaches high point
Other: labor costs high, sales low, inventories high compared to sales.

The Recovery
This is the expansion phase where output and employment increase.
Economy: steadily expanding
Profits: increasing
Savings: starts to decrease
Spending: increasing
Output/Production: increasing
Employment: increasing
Bankruptcies: decreasing
Inflation: stable
Other: Sales are on the upturn.

Some industries or sectors are more affected by downturns than others. Examples are producers of consumer durables (like automobiles and household appliances), producers of capital goods (especially machinery to produce commodities like gold or iron ore), and the construction industry.
How do you predict when the cycle is changing to adjust your investment style? One way is to look at economic indicators. There are three main classes of economic indicators: leading, coincident and lagging. A leading indicator is an early indication of a new trend, a coincident indicator shows the new trend as it is happening (not before it starts) and a lagging indicator shows the new trend after it has already developed.
Here is a list of indicators to watch:
Leading indicators:
•Changes in business and consumer credit
•Average weekly manufacturing hours
•New orders for plant and equipment
•New orders for durable goods
•Housing starts
•Initial claims for unemployment insurance
•Delayed deliveries by vendors
•New businesses formed
•New building permits for private housing
•Material prices
•Stock prices

Coincident indicators:
•Nonagricultural payrolls
•Personal income
•Industrial production
•Manufacturing and trade sales

Lagging indicators:
•Duration of unemployment
•Outstanding loans
•Average prime interest rates charged by banks
•Ratio of consumer installment credit to personal income
•Change in labor cost per unit of output
•Ratio of manufacturing and trade inventories to sales

Hopefully your eyes haven’t glazed over by this point. The thing to focus on is that there are indeed ways to determine if the economy is on the way up or down or stuck somewhere in between. Most of these indicators can be found on the Internet. Just do a keyword search on any of the terms above.
It’s also wise to notice that in the current economy you really need to look at sectors (like energy, tech, financial, gold, etc.) and see how each of these are doing. Certain sectors will generally perform much stronger than others and by identifying the business cycles in each sector you will be in a much stronger position to make profits with your investments.

Scrooge