Analysis of Business Cycle for Stock Investment

Business cycles represent a complex control system with many causes and interacting private and governmental decisions. For example, companies invest in plant and equipment and build inventories based on expected demand but face the reality that actual demand does not continuously meet expectations.

Business Cycles and Investment Opportunities

Although an investor would benefit from buying stocks at the trough of a business cycle and bonds at the peak, such perfect market timing is virtually impossible, and one might better take the approach of ignoring the business cycle and concentrate rather on its long-term sustainable growth rate in GDP. Nevertheless, even limited prescient ability can lead to informed adjustments to portfolio holdings.

There are five stage of business cycles: recovery, early upswing, late upswing, economy slows and recession. Recovery: The economy picks up from its slowdown or recession. Good investment to have are the country's cyclical stocks and commodities, followed by riskier assets as the recovery takes hold. Early upswing: Confidence is up and the economy is gaining some momentum. Good investments to have are the stocks and also commercials and residential property. Late upswing: Boom mentality has taken hold, This is not usually a good time to buy the country's stocks. The commodity and property prices will also be peaking. This is the time to purchase the bonds (yields are high) and interest rate sensitive stocks. Economy Slows or Goes into Recession: The economy is declining, Good investments to have are the bonds, which will rally (because of a drop in market interest rates), and its interest-rate-sensitive stocks. Recession: Monetary policy will be eased but there will be a lag before recovery: Particularly toward the end of the recession investments to make are the country's stocks and commodities.

Stock Market Performance and Business Cycle

Stock market performance is clearly related to the business cycle and economic growth. National business cycles are not fully synchronized. This lack of synchronization makes country analysis all the more important.

However, economies are becoming increasingly integrated. Growth of major economies is, in part, exported abroad. For example, growth in the United States can sustain the activity of an exporting European firm even if demand by European consumers is stagnant. But rigidities in an national economy can prevent it from quickly joining growth in a world business cycle.

What are the business cycle synchronization implications for equity valuation? Although national economies are becoming increasingly integrated with a world economy, there are so many economic variables involved that the chances of full synchronization are extremely remote.

Business Cycle and Investment Diversification

The lack of perfect business cycle synchronization is an a priori argument in favor of international diversification. If long-term GDP growth and business cycles were perfectly synchronized among countries, then one would expect a high degree of correlation between markets, especially in periods of crisis. In making investment asset-allocation decisions, one must always consider long-term expected returns, variances, and correlations. Iii the long term, international diversification will always be advantageous until national economies are expected to be perfectly synchronized around the world. It is difficult to imagine such a possibility. Expected returns and expected standard deviations will differ among countries with unsynchronized short-term business cycles and long-term growth rates, even though investors may follow the crowd in their short term reactions to crises.