Business Cycle Coincident Indicators

The previous blog gave information on the leading indicators for a business cycle. This blog gives the coincident indicators or the indicators that coincide with performance of Gross Domestic Product, GDP.

These indicators give confirmation of where we are in a business cycle. While these indicators are important from a confirmation perspective they are not as useful to an investor as the leading economic indicators.These coincident economic indicators include:

• Industrial Production
• Personal Income
• Employment
• Average Number of Hours Worked
• Manufacturing and Trade Sales
• Non Agricultural Employment
  

As GDP increases, these indicators should also increase. Conversely, if GDP decreases these indicators should also decrease. As you watch the performance of these indicators, you should see confirmation with GDP.

While this is good economic data. I follow the 4 leading economic indicators more closely for making investment decisions. Do not confuse a coincident indicator with a leading indicator.

Business Cycle Leading Indicators

Previous blogs have given information on the business cycle for our U.S. economy. Gross Domestic Product, GDP, is measured to see where we are in the business cycle.

Wouldn't it be nice to know where we are in the business cycle ahead of time? If we did we could make better investing decisions. We can get a picture by looking at something call leading economic indicators or the things that move ahead of the GDP measurement.

The leading economic indicators include:

• Building Permits
• Stock Market Prices
• Money Supply (M2)
• New orders for consumer goods
• Average Weekly Initial Claims in Unemployment
• Changes in Raw Material Prices
• Changes in Consumer or Business Borrowing
• Average Work Week for Manufacturing
• Changes in Orders for Durable Goods

The things I watch are:

1. Stock Market Prices - going up now after a decline
2. Money Supply (M2) - going up, increasing by about $200 Billion in the 1st Qtr 2008 alone. A few data points to illustrate the trend. (January 2007 = $7.1 Trillion, January 2008 = $7.5 Trillion, March 2008 = $7.7 Trillion)
3. Changes in Raw Material Prices - going up (I think that is more of a global indicator rther than just a U.S. indicator now)
4. Average work week for manufacturing - this should be going up due to value of the dollar relative to other currencies.

To me this indicates that our economy is not in a contraction mode. It appears to be in a trough or early expansion mode.

Bottom Line: Do not let the news get you down.

Current Status of U.S. Business Cycle

The last blog looked at the features of a business cycle. Typically, we think of the U.S. economy business cycle. Let's look at the current environment for commodity prices and interest rates relative to the business cycle of the U.S. economy.

In an expansion, commodity prices are rising because of higher demand and interest rates are rising to contain inflation. In a contraction, commodity prices are falling because of reduced demand and interest rates are falling to stimulate the economy. It would be easy to tell which stage we are in if all of the indicators were going in the same direction. However, this typically does not occur.

Let's look at the cost of gold, the fed funds rate, the 10 year treasury bond rate, and the value of the dollar relative to other currencies and see what they tell us about the current status of the U.S. economy business cycle. Gold has gone from about $1,000 to $900 per ounce. Fed Funds rate has been reducing and the experts predict another 0.25% reduction. The 10 year treasure bond rate has been rising recently from a low of about 3.28% to recently 3.82% while the Fed has been reducing the Fed Funds rate. The dollar is close to an all-time high relative to some other currencies

If you listen to the news, the message is that the U.S. economy is either in or going into a recession. Remember that a recession is 6 months with negative growth in the Gross Domestic Product, GDP. Since the economy is the #1 political topic in the current election. The democratic view is that we are in a recession. The republican view that we are in a slowdown.

Based upon the data, who is right the democratic party or the republican party? The data is telling me that the republican view of a slowdown is correct. Why? I do not believe that we will have 6 months of negative GDP. What is the logic?

• The reduction of the Fed Funds rate indicates a contraction.
• The increase in the 10 year Treasury bond rate indicates that we have gone through a trough and have started an expansion. The bond rate has been increasing while the Fed has been reducing the Fed Funds rate which seems rather unusual on the surface. The Treasury bond rate is a better leading indicator than the Fed Funds rate.
• The decrease in the price of gold suggests that the economy has peaked and is entering a period of contraction. This is a bad indicator for our economy and is a better indicator for the global economy.
• The value of the dollar makes it more attractive for products made in our economy to be sold globally. It helps increase exports and reduce imports. This helps our economy expand in the future.

The Fed Funds rate is telling us that our economy is in a trough. The 10 year Treasury bond rate is telling us that our economy is past the trough and will be expanding. The value of the dollar helps our economy.

Bottom Line: Do not listen to the doom and gloom. The indicators suggests that our economy is at a trough in our business cycle starting to enter an expansion in the future. Do not be afraid of purchasing mutual funds that invest in stocks if it fits your risk tolerance.

Understanding Business Cycle

The measure of the health of our economy is the Gross Domestic Product, GDP. It measures the value of all goods and services produced in the United States including consumption, investments, government spending, and exports minus imports. The GDP is reported by the government on a quarterly basis.

GDP goes through periods of time where it gets bigger and smaller. When GDP gets bigger it means that businesses are expanding and is called business expansion. When GDP gets smaller it means that business is shrinking and is called contraction. The business cycle has 4 stages: expansion, peak, contraction, & trough.

Since data is reported historically, we only know the health of the economy for the previous quarter and not how healthy we are in the current quarter. GDP is not a leading indicator for an investor because it takes the measure of economic health in the past. Do not invest using a GDP report.

In an expansion, business is growing and can be measured by the following being higher: GDP, consumer demand, corporate sales, manufacturing output, wages, savings, real estate prices, and stock market. Along with these going higher, the Federal Reserve, Fed, is raising interest rates and slowing the money supply to fight inflation.

At a peak, these things stop growing and the Fed is holding interest rates and the supply of money.

In a contraction, everything flips and we have lower: GDP, consumer demand, corporate sales, manufacturing output, wages, savings, real estate prices and stock market. The Fed is lowering interest rates and increasing the money supply to stimulate the economy to avoid a recession or depression. A recession is 6 months of contraction while a depression is 18 months of contraction. Another definition is a recession is when your neighbor loses their job and a depression is when you lose your job.

At a bottom things stop falling and the Fed is holding interest rates and the supply of money.

Watching stock prices, interest rates and commodity prices tell us where we are in a business cycle.

The next blog will be on where the United States economy and global ecomony are in the current business cycle.

Irrational Behaving Markets

My favorite investment book is "A Random Walk Down Wall Street" by Burton G. Malkiel. This is a good book for any investor. At the end of Chapter 3, a little paragraph summarizes irrational behavior in the stock market or any other market such as interest rates or commodities.

An underlying assumption that investors make is that the markets are both rational and efficient acting in a predictable manner. While this is true most of the time, it is not true all of the time. "The market evantually corrects any irrationality-albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic and often they attract unwary investors. But eventually, true value is recognized by the market, and this is the main lesson investors must heed."

Yesterday's blog touched on this topic. Because of numerous factors any market can act irrationally for a period of time. People only know that it was irrationally high after a correction or irrationally low after a bounce. It is kind of like driving by looking in the rear view mirror. A savvy, disciplined, or just plain lucky investor can sometimes recognize irrational behavior and make money.

An investor that goes with the flow will buy toward the top and sell toward the bottom. Human nature wants to invest in a proven winner because it makes us feel good. Human nature wants to get rid of something that seems like a failure. This means that we tend to buy late and sell late. The more money we lose the greater amount of pain.

From painful experience, I can tell you some of the signs of irrational behavior:

• It seems that everyone is talking about it. It is on the news. Everyone seems to become obsessed about it.
• A statement is made by someone in the know, whomever that is, that the price is just going to keep on going as if the trend will continue forever. Reasons are given and on the surface it makes sense. After challenging a few assumptions, it becomes obvious that this is just repeating what someone else said without a justification.
• The investment has a track record of going up at a fairly steady rate for a substantial time period such as housing prices have been going up on average at about a 5% rate for the last 40 years.
• The rate changes by a significant amount each year for a while, like a few years.
• The price is much higher than any historical level such as a price of 100 times earnings versus 20 times earnings or $1,000 per ounce versus $300 per ounce.
• A herd mentality exists because somebody has recently made lots of money with this investment and the herd joins because they want to become a winner.
• The price has some fluctuations at the top but always seems to bounce back. The stock price goes up or down by 5 - 10% in a day. If it goes down 5% today, surely it will bounce back this amount tomorrow.
• An event happens, like a comment from an expert or the publication of a report and all of a sudden the thing that was going to keep the price climbing higher didn't.
• The price comes down over time, like a staircase, in a painful fashion.
• If you ever say surely it can't go any lower than this, you know that you are in trouble. This is a statement to justify hanging on to it. If you say this, SELL.

It is relatively easy to not get burned. If you own a stock, place a stop loss sell order at a price that you would be happy to get if something went wrong, so if this something happens you will still be happy. If you own some mutual funds and one gets rather excessive in proportion to the rest then sell some of it to get your portfolio back in balance.

Don't learn this lesson the hard way like I did. Profit from my mistake.