r2i forum

Friends – Thanks for everyone in this forum for your invaluable contribution and am going to raise an important topic which I feel is not covered. As we all know there are 2 major type of investing strategies such as investing in Index funds which is pretty simple and the other one is to understand the direction of business cycle and investing appropriately. The first strategy ‘Indexing’ is covered a lot and the second strategy ‘Prediction of Business Cycle for investing’ is much more difficult even for professional economists. However, the focus of this thread is to understand the basics of how the investing strategies should be in economic cycles such as ‘Recession’ and ‘Boom’ period. I will summarize what I learnt so far in a flow-chart and hope our forum experts will give their views. Hopefully fence-sitters can throw in their views and let’s make this discussion fruitful.


When Boom Period Ends → Corporate Profits Dwindle → Recession Appears → Inflation Tends to be Low → Federal Reserve Lowers the Interest Rates → Stocks Fall → Bonds Raise → Hard Assets such as Real Estate, Gold, Silver, Commodities Increase → The best time to invest in Bonds and Hard Assets is when the boom period is above to end and recession sign starts.

When Recession Ends → Corporate Profits Rise → Economy Pick up → Inflation Increases → Federal Reserve Raises the Interest Rates → Stocks Raise → Bonds Fall→ Hard Assets such as Real Estate, Gold, Silver, Commodities Fall → The best time to invest in Stocks is during a Depressed Recession and when bull market is above to appear.

Now, my questions are:

(1) Is the above flow-chart correct and in orderely manner? If not, please correct it.
(2) What is the relationship between Recession and Inflation? How does it happen?
(3) There are several tools available to predict the business cycle. Can you name a few tools which can be useful for predicting the end of boom and bust cycles?

Love India,

Quite solid topic boss and articulated very well. Would love to learn more on this front.

Here is what me thinks

Interest rates goes down --> Corporate borrowing goes up ---> capital expenditure/capacity building goes up --> employment goes up ---> higher wages ---> higher spending ---> inflation goes up --> interest rates goes up and you are in the never ending vicious circle.

Not so simple. Take 1973-1975 for example for S&P 500 companies

Year Profit growth Stock Returns
1973 +25% -15%
1974 +21% -26%
1975 -18% +37%

There is very low correlation between year to year profit growth and stock market returns.

The type of analysis you are performing is commonly referred to as Top-down or Macro forecasting. The main problem is that there are lots of variables and each variable interacts with the other. So you need to get all the variables right to get the forecast correctly. Take a look at all the people who have had performed well in the stock market over the long run - there are very very few who have done the macro way. Almost all have done it from a bottom up approach.

The Fed has a 3000 variable model to predict the economy and even they dont get it right very often.

The second issue is that market is adaptive so strategies that worked once stop working when a lot of people start using it, so you need to constantly adapt. Think of stock market as a non-linear complex adaptive system.

Not saying that indexing is the only way to go, just that the Macro approach is not a good approach if you want to be successful in the stock market.


Vinod

Along with the factors mentioned try adding globalization to the mix and the picture as clear as the one drawn by a monkey with its left hand. It is that unpredictable nature that makes stocks as interesting as they are. It is a futile experience to predict the stock market in the short term. However macro analysis can be used to predict a reasonably long term and the business cycle. In Jim Cramer's book Real Money there is a business cycle - sector rotation map that is very helpful. Even if you hate the guy take a look at that picture (and ignore his specific stock recommendations) and it is a very reasonable guide to follow.

Well all of this was valid when US was the only major economic force in the world. Now with the galloping emerging markets and the recovering Europe things get really murky. As an example with broad economic slowdown in US a company like Caterpiller should have hit a rough patch now. But it still survived the past year because it did well internationally and the currency played in its favor.

So is it impossible to predict stocks ... no not at all. In fact it is possible to reasonably predict a stock in the long term (> 2 years) with a business cycle approach. You definitely have a more than 50% chance with a good research and barring any catastrophies.