In previous articles we have discussed how policymakers influence the economy and how to understand the possible future effects of policy decisions on the economy. In this third blog post we will tie this into the business cycle and offer practical suggestions for understanding where we are in the business cycle and thus what assets should perform well.

Business Cycle = Debt Cycle

The business cycle simply refers to the alternation of  economic expansion and economic contraction, which tend to happen every 8-9 years. The business cycle approach to investing and trading offers the potential to take advantage of relative outperformance of certain assets in certain phases.

The first thing to note is that GDP growth is driven, more than anything else, by bank credit. Easy monetary policy, which is usually utilized to stimulate the economy, is actually “leverage” and acts as a sort of doping. While the economic machine would naturally need to cool down, and establish an equilibrium at a lower level, policymakers (convinced that they can control the economy) inject credit into the system and the old problems never get weeded out.

Hence, in order to understand where we are in the cycle, the first port of call is the amount of credit in the system and the rate of change: is credit still expanding or is it contracting?

Also note that the Consumer Price Index (CPI) is NOT very correlated with GDP growth rates or credit availability. And yet inflation is what the central banks target, in order to justify their actions. No wonder central banks are seemingly behind the curve.

What is quite correlated with GDP growth is industrial production and we should not be surprized: after all, long-term economic growth is all about a population’s productivity – not about the amount of natural resources present in the country.

Business Cycle Phases

1. Early Recovery/Expansion phase : in this phase, consumer confidence and industrial production are strong. Leading indicators are rising, retail sales are rising, inflation is rising, inventories are dropping, commodities are rising and tendentially:

  • stocks outperform bonds
  • Consumer Discretionary stocks outperform the market
  • Utility stocks underperform the market

2. Expansion/Mid Phase: in this phase, there is a slowdown in consumer confidence and industrial production, while interest rates are rising and catching up. Unemployment is still dropping, inflation is still rising and tendentially:

  • commodities outperform stocks
  • stocks continue to outperform bonds
  • there is a slight outperformance of information technology stocks, but performance is usually strong across the board

3. Slowdown/Late Phase: in this phase, leading indicators start to drop, consumer confidence begins to drop as does industrial production. Interest rates are still rising and so is unemployment. Inflation is slowing but not turning lower just yet. Commodities are spiking and tendentially:

  • bonds become more appealing compared to stocks
  • energy stocks outperform the market
  • consumer discretionary underperforms the market

4. Recession: in this phase, unemployment rises strongly, GDP growth is negative, inflation is dropping, commodities are dropping and tendentially:

  • bonds outperform stocks
  • consumer staples outperform the market
  • information technology and industrials underperform the market

And this is what the relative performance looks like on a chart:

Getting Creative

To be honest, given that markets are populated by humans and that the economic machine is driven by productivity, I would like to suggest an alternative – less academic – approach. Let’s go back to the basics: for main street, the various phases of the business cycle are irrelevant. To main street, the only things that matter is confidence.

  • Is the outlook for the economy good? Business as usual.
  • Is the outlook for the economy bad? Recession!

By using a more behavioural approach, we can simplify the analysis by comparing extremes:

Industrials vs. Utilities

Consumer Discretionary vs Consumer Staples

And now let’s close the circle by connecting Consumer behaviour to the credit cycle:

As you see, main street isn’t stupid. Consumers shift their habits in advance of credit contraction and recession. After all, the economic data that comes out each week has taken time to be compiled and is, to a certain extent, old news because it reflects a behavioural shift that already happened.

Over to You

Following the business cycle really isn’t that difficult, if you know where to look.  In this article we have explored a simple behaviour-based method that can allow you to assess with a certain degree of robustness where we are in the business cycle, and position yourself appropriately. Remember that policymakers create the environment within which we all live & act, but policymakers cannot control the economy – or our behaviour.

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.