My wife and I were stuck in airports in Texas during the recent storms there. To pass the time, I was reading business magazines and newspapers. A woman seated next to me noticed this and asked why the investments in her 401(k) plan were performing so miserably. I replied that perhaps she was invested in the wrong phase of the business cycle. She asked, "What is a business cycle?"
The fact that so few people know about the business cycle is not surprising when you consider how many people have not made any money in the stock market in the last several years.
This business cycle is currently dominated by an anomaly-a once-in-many decades occurrence that is uncharacteristic of most all other business cycles. This business cycle's recession was caused indirectly by the Y2K phenomenon and its boom phase was exacerbated by the fall of dollar value and interest rates that had bottomed at 45-year lows.
When something like this has never quite happened quite like this before, it is an anomaly. When you have a different cause, you have a different effect. Unless you understand how the money flow business cycle works, you will probably be like the frustrated 401(k) investor I met in the airport-without a clue.
Let's take a moment to review some money flow basics. The Federal Reserve Bank controls interest rates and the level of liquidity in its banking system. It controls over 75% of our nation's economy (Gross Domestic Product, or GDP). As measured by the government, our nation's GDP is composed of wholesale and retail sales-about 75% of GDP. Another 10%-18% is made up of military spending.
To make the economy move up, the Fed must encourage consumers to spend. Since most major purchases are made on credit, the interest rate involved determines the final price the consumer pays. The lower the interest rate, the lower the final cost and vice versa.
If the Fed pushes interest rates too high, fewer consumers can afford to purchase goods. Eventually, high interest rates cause a recession. If interest rates are kept too low for too long, inflation follows. Prices rise, wages soar. At this point in the business cycle, the Fed pushes interest rates higher and higher.
To keep selling their goods, wholesalers and retailers must cut costs and/or sacrifice profits to keep prices at levels consumers can afford. Eventually, profits are too low and stock prices fall. This marks the top of the market.
The next phase of the business cycle is a recession. Once prices have retreated to levels that satisfy the Fed, it starts to lower rates and this is called the re-liquefaction phase. When the price of goods becomes affordable, consumers again buy.
The next phase is the profit phase. At this point, wholesalers and retailers start to make a profit, the stock market starts to rise, and so does the economy.
If this was all there was to it-interest rates, profits and price inflation-following the business cycle wouldn't be that difficult. Obviously, there is more.
There is discounting and there is lead time. The market discounts the success or failure of every phase of the business cycle. When the market moves up, it is discounting better times in the economy. Vice versa, when it moves lower. When it moves sideways (a narrow trading range), the market can't see the future.
To further complicate the business cycle's movements, there is dollar value. For now, when the dollar moves up, it makes imports cheaper and when it moves lower, as it is currently doing, foreign goods become more expensive.
So, where are we in this business cycle? We are in the boom phase. The declining value of the dollar is enhancing the current boom phase. What does this mean for investments? It means you go with the trend. For now, the trend is rising prices and a weaker dollar. The sure benefactors of this trend are precious metals, oil and gas, and real estate in select areas. Since there is a war, defense stocks should also be considered.
As the dollar moves lower, many more stocks will become bullish. STAY TUNED!
Kenneth Coleman
