In Chapter 1 we touched on information that disseminates from Wall Street and why participants cannot blindly follow the advice, direction, and research of others. The question raised, then, is where do participants find nutritious market food? Good food is available once responsibility is accepted to do one’s own research and in the course of doing so also measure personal financial risk. It is found under the guise of the market behavior of its participants—or crowd psychology. This market psychology, as we will refer to it, is manifested through the business cycle, and before we can direct our attention to specific methods of market engagement, we must understand this cycle.
Before exploring and defining the business cycle, it is imperative for all participants to understand market principles and the possible influences they have on the markets. Seeing the market from the macro level is truly seeing the forest from the trees, and avoiding the often-myopic view participants develop. In fact, understanding the complexities of inter-market relationships will open up all participants’ eyes to a number of important facets that take place in the market daily, uncovering many trading and investing opportunities. Conditioning the mind to only see one perspective of the market not only limits opportunity, but also expands risk. As you will discover throughout the text, the proper understanding and perspective of the economic process will define perhaps the most important questions of the market—when to have conviction and when to be disciplined. To borrow a cliché from the card playing community—you gotta know when to hold’em and when to fold’em.
In addition to understanding our domestic economic process and its effects, market engagement has certainly rooted itself globally, so the importance of world events also cannot be ignored. The process of analyzing the markets from a macro level and filtering data to a micro level is referred to as top-down analysis. The logical beginning of this analyzing process is an explanation of the business cycle. The term business cycle describes economy-wide fluctuations in output, incomes, and employment. Basically, a business cycle can be described as the upward and downward movement in an economy’s aggregate output. Looking back in history, there have been many constant predictable periods of low output generally followed by periods of expansion. Therefore, a cyclical trend can be established and used as a benchmark going forward. Time and history have proven the cycle over and over based on many different drivers connected by one enduring ingredient—risk. Without the element of risk, the business cycle would be at the hands of oracles and soothsayers. Risk represents the adventures of man, and perpetuates the cyclical nature of capitalistic markets. Risk is what makes the future our friend. The anticipation of what may occur drives excitement, hope, fear, and uncertainty. These emotions are manifested in perfect harmony with the economic cycles of our nation and much of the world. Essentially, the business cycle reflects the byproduct of sentiment and emotion. This makes the cycle measurable and therefore somewhat predictable, but only if seen from the higher ground. In modern day western society, our economy can be viewed as a giant machine. This machine requires lubrication in order for it to run as efficiently as possible. This does not guarantee the machine won’t occasionally run rough, but as history has proved, our machine of capitalism continues to avoid breakdown and represents the smoothest economic and political mechanism on earth. Perhaps the most important gear in our economic machine, as it applies to the business cycle, trading, and investing, is the Federal Reserve (Fed). One of the commonly accepted roles of the Fed is to control swings in the business cycle, accomplished by influencing interest rates and the money supply. The Federal Open Market Committee’s (FOMC) monetary policy setting power gives it the ability to influence these aspects of the economy through the buying and selling of government securities and the governance of short-term interest rates.
Therefore, the Fed will loosen monetary policy when output seems to be slowing and tighten when economic expansion appears to be rapid. Accelerated expansions tend to fuel inflation, which can undercut long-term growth. These expansion cycles can last for years (typically three to five) before reversing, and the state of the economy will certainly be influenced by the actions of the Fed regarding interest rates. The Fed and their role in the economy will be discussed in greater detail in this chapter. For now, understand the components of the business cycle as explained below and the impact the Fed has on it.
The components of the business cycle are outlined below:
• Expansion—Also known as recovery, expansion is characterized by increases in business activity throughout the economy. The expansion stage is actually the normal state of the economy.
• Peak—As activities expand to a peak, employment and income rise. When near full employment is reached along with rising incomes, we refer to this period as prosperity (inflation).
• Contraction—As business activity begins an overall period of decline, the economy is said to be going through a contraction. If there is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters, the official term is recession. GDP is defined as the annual economic output of a nation (all of the goods and services produced by the workers and capital located within it). It is important to note that recession does not take into consideration changes in other variables. Changes in the unemployment rate or consumer confidence are ignored, and using quarterly data makes it difficult to pinpoint when a recession begins or ends. This means that a recession that lasts 10 months or less may go undetected. More severe contractions of longer duration (any economic downturn where real GDP declines by more than 10 percent) may be deemed depressions. The last depression was from May 1937 to June 1938, where real GDP declined by 18.2 percent.
• Trough—At the bottom of a contraction is a period in which business activity stops its decline and begins the long road back through expansion toward prosperity. This bottom of the business cycle is known as a trough.
There are some patterns found within the business cycle, and these are published by the Department of Economics at the University of Minnesota. One pattern suggests that expansions generally last longer than recessions, with the average post-World War II expansion lasting about 50 months, while the average recession lasted about 11 months. Therefore, the average post-World War II cycle was about 61 months, or five years. This said, participants could begin to understand the timing aspect of the business cycle as it applies to markets.
Economists love to talk about where we stand in this cycle, and they use many forms of measure to make their arguments. While it seems that there are as many views as there are economists, as quoted by John Kenneth Galbraith in the Wall Street Journal (January 22, 1993, C1): “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” The one common theme to all arguments is short-term interest rates. Short-term rates are a common focus because both consumers and producers are directly impacted. They represent the best variables as they relate to the financial market, in the way of bond prices and yields via pricing in the next cycle of the economy. In other words, many economists believe that the bond markets will directly influence the stock market in a forward-looking manner. It is therefore important to understand which indicators are leading, coincident, or lagging with predicting the economy.
• Leading indicators—Leading indicators are those factors that appear to reliably predict trends in the economy. They give us a heads up idea of where the economy is headed. Leading indicators that economists use most often include and are directly influenced by the cost of money (interest rates):
• Hours of production workers in manufacturing
• New claims for unemployment insurance
• Value of new orders for consumer goods
• S&P 500 Index
• New orders for plant and equipment
• Building permits for private houses
• Fraction of companies reporting slower deliveries
• Index of consumer confidence
• Change in commodity prices
• Money growth rate (M2)
Positive changes in any of these leading indicators (such as a bull market, expansion of the money supply, issuance of more building permits, and increases in orders for consumer goods or plant and equipment) lead economists to believe that there will be more spending, production, and employment in days to come. Negative changes in leading indicators give rise to a more pessimistic outlook among economists and politicians, as possible downturns and recessions loom. Simply stated, when the cost of money is low, increases in money supply fuel consumer and producer spending.
• Coincident indicators—Coincident indicators are those measurable factors that vary directly and simultaneously with the business cycle. They tell us where we now are. Coincident indicators include:
• Nonagricultural employment
• Personal income
• Index of industrial production
• Manufacturing and trade sales
Personal income and industrial production are representations of what is already “in play.” Production, for example, represents that the machines are already running, while changes in interest rates may affect output if they stay running. This is an oversimplified example, but it puts the indicators in context of the economist view.
• Lagging indicators—Lagging indicators are those factors that change after the economy has already started to follow a pattern or trend. They tell us where we were. Lagging indicators include:
• Average duration of unemployment (in months between periods of employment)
• Ratio of deflated inventories to sales, manufacturing, and trade
• Labor cost per unit of output (manufacturing)
• Commercial and industrial loans outstanding
• Corporate profits
• Ratio of consumer installment credit to personal income
The indicators speak for themselves. For example, corporate profits are directly affected by the cost of money. When short-term rates rise, earnings for most corporations are adversely affected as we will discuss in greater detail in Chapter 3.
As you can see, these indicators and clues are a cross section from the Stock, Bond, and Commodity markets. The importance of following the reports given throughout the year can help the trader and investor see the big picture and the trends that are building. While this view is far too broad to make any investment decisions, perhaps its greatest value is to help form one’s conviction about the maturity of the stage of the business cycle. In fact, the stock market has predicted 12 of the last 18 recessions. Looking at Figure 2-1, there is a general tendency for bond prices to rise as the business cycle enters and deepens into the contraction cycle. During the trough phase, equity prices tend to rise and the stock market begins to price in or anticipate better times, portending a move into the expansion cycle. During this expansion cycle, commodity prices rise, and there is usually a general pick-up in inflation. The economy will continue to rise and handle the inflationary pressures within the manufacturing pipeline and at the retail level, until eventually there is a peak in the cycle (preceded by a move lower in bond prices). Coming full circle, stocks (as well as commodities) fall and we once again enter the contraction phase. Having this broad understanding will help keep a proper perspective of the financial marketplace.
FIGURE 2 - 1 This illustrates the common relationship among stock, bond, and commodity prices in relation to the business cycle. This understanding alone will help participants to direct attention to various investment vehicles during the stages of the cycle.
The Government is the single largest spender in the economy, which means its impact on the markets is the largest. When the economy is zipping along at full employment, deficit spending by the Government is a bearish indicator because the issuance of Government debt competes with corporate bonds for the public’s money. This tends to lead to higher interest rates, as competition for money requires a stronger yield (coupon). Excess Government spending can also lead to inflation and force the Fed to raise short-term interest rates. Either way, higher interest rates make interest-earning securities or money market accounts relatively more attractive, and this siphons off money from the stock market. The size of the federal debt is such a big issue in the minds of investors that just about any attempt to reduce deficits short of raising interest rates is greeted with enthusiasm by Wall Street. However, when the economy is clearly in the contraction phase of the business cycle, deficits are bullish because the additional spending by the nation’s largest spender leads to a lot of economic activity in the private sector.
If the Government decides to slow down an overheated economy, it can do so in several ways, including:
• Raising taxes
• Reducing the money supply (tight monetary policy)
• Reducing Government spending
Each of these activities reduces consumer demand, business spending, and investment. On the other hand, if the Government decides it would be beneficial to stimulate a sluggish economy, it can do so by:
• Reducing taxes
• Increasing the money supply (easy monetary policy)
• Increasing Government spending
These activities stimulate the economy by encouraging consumer demand, business, and investment spending.
Once you begin to understand the complex nature of the domestic economy without further complicating it with the World economy, you can then understand the nature of the business cycle and the impact the two primary players (the Government and the Fed) have on it. Remember this always—the act of understanding and forecasting the economy is the work of economists. The ability to anticipate the reactions of the far less educated amateur participants is the work of traders. The public represents the less educated participant (dumb money). Therefore, your role here is to understand, not predict nor forecast, the economy. Through understanding, you gain an insight into the likely reactions of participants. As economic news is disseminated to the market nearly every day, these reactions tend to cause overreactions since the amateur tends to act like an economist, trying to relate the news into forecasts that have little to do with the current market. Economic news in almost all cases (the exception would be the FOMC, which will be discussed in Chapter 3) is much more forward-looking. The confusion of amateurs is perpetuated because they associate the sudden volatility in the market with the news released. The media helps this misconception as well. In fact, professionals hide behind the news as the cause for the volatility, but their true motivation is to “fade” the anticipated public reaction or go the other way. The public’s emotional reactions of buying and selling are most often directly countered (faded) by professionals taking the opposite side of the transaction. The moral of the story is to understand the economic news and information well enough not to react like the public, or fade the public reaction like a professional.
The Federal Reserve Board’s policies on the size, movement, and growth of the money supply compose its monetary policy. The Federal Government’s policies on taxation and spending make up the country’s fiscal policy.
Money and banking are directly and immediately impacted by the Fed’s monetary policy.
• The Fed’s most important and flexible tool is open-market operations. When engaging in open-market operations, the FOMC buys or sells U.S. Treasury bonds in the open market in order to expand or contract the money supply. When the economy is sluggish and the Fed wants to expand (or loosen) the money supply, it buys U.S. Treasuries from member banks. By selling bonds, the banks receive cash that they can use to make new loans, thereby increasing the money supply. If the economy is in danger of overheating and the Fed wants to contract (or tighten) the money supply, it sells U.S. Treasury securities to banks. By selling securities, the Fed pulls money out of the banking system, forcing banks to make fewer loans and contracting the money supply. The Fed’s second most important tool for affecting the money supply is raising and lowering the discount rate—the interest rate the Fed charges its members for certain very short-term loans. By lowering the discount rate, the Fed tends to stimulate the economy by making it easier for banks to make new loans. By raising the discount rate, the Fed tends to counteract inflation by making it more difficult for member banks to make new loans.
These decisions are made eight times per year. In the simplest way, traders will want to avoid having a position going into an FOMC meeting and leave the guesswork of its outcome to the gamblers. This is the one time that all positions should be closed and both traders and investors should stand aside. Traders using a technical approach will better serve their interests to trade a reactionary move than to try to predict the unpredictable. This is why gambling Web sites allow people to make bets on the outcome of an FOMC meeting—it’s a gamble.