A Brief Overview of The Business Cycle
The business cycle demands attention to housing, finance, and resources. Additionally, we continue to focus on a few select trends: consumer technology and health.
What is the business cycle? The idea that the basic economy moves in a 4 part cycle and that investing can succeed by following the cycle. Here is an approximate way to think about it:
Part 1 – Post recession. Manufacturing is picking up, consumer spending is still uncertain. Corporate fundamentals are stabilizing. Invest in equities. Avoid bonds.
Part 2 – Growth. Demand is strong across all sectors. Interest rates begin to rise. Invest in equities, finance stocks and commodities (companies begin to experience pricing power). Unemployment drops. Avoid bonds.
Part 3 – Coasting. People have bought what they need, interest rates continue to rise to moderate growth. Signs of oversupply and overinvestment begin to show. Unemployment continues to be low. Avoid commodities and start to shift away from equities and towards bonds.
Part 4 – Downturn. Demand is dropping. Interest rates begin to drop. Buy bonds.
As you can see, anticipating the next phase allows one to shift away from softening sectors and into ramping sectors.
I think that we are entering Part 3. Housing is slowing. Consumer durable purchases are slowing. Interest rates are slowing their rise. Commodity prices are starting to soften and consolidations are picking up (a basic way to leverage a cash stockpile and show additional profit growth).
Here’s a great chart of historical economic activity; it shows the biz cycle in action
http://jec.senate.gov/_files/ISM3Mar2006.pdf
Start with the blue line for manufacturing activity: it began slowing in 2000 until bottoming out in 2001. It drifted until 2003 and was strong for 2004. It remained stable and string in 2005 (though not nearly as strong as 2004).
2002~2003 – Part 1. Growth but not solid.
2004~2005 – Part 2. Solid growth. Demand for consumer durables and commodities surges.
Lets shift now to the numbers.
GDP Growth – In Q4 2005, GDP grew at its slowest rate in three years — 1.1%, which is down from 4.1% growth in the third quarter. (Here’s a great chart http://jec.senate.gov/index.cfm?FuseAction=Charts.Detail&Image_id=136)
Before we panic, look at that chart and you’ll see that Q4 is always the weakest quarter. Which makes sense – it’s the big shopping season and manufacturing and inventory buildup peaks in Q3 as retailers and producers stock up. Q3 2005 was quite respectable compared to Q3 2004.
First of all, Q3 was all about dealing with Hurricanes. That cooled as we moved into Q4. Second, consumer spending is slowing. Ummm, that’s exactly what we should expect to see: that’s what the Fed is driving towards. Housing and cars in particular dropped: two sectors sensitive to interest rates. But I think another factor is at work here: buyer exhaustion. Starting in 2001 and accelerating in 2002, consumers were invited to spend spend spend. New cars, new washing machines, new houses. People don’t need to replace all of this new stuff just 3 years later. Come on – did anyone expect this level of spending to continue???
As spending starts to slow, inventory buildsup: bingo! That happened in Q4. Next, excess inventory gets dumped and imports sag a bit.
That will hit earnings – highflying tech stocks will get hit as will any company selling consumer products with overly aggressive expectations. Earnings will grow at slower rates.
We want to find the products where prices are not dropping: Mobile entertainment and home entertainment, Titanium, healthcare.
Our 2006 approach should be that consumers are catching their breath in the 1st half (repairing their balance sheets, paying taxes) and then things will pick up in the 2nd half. We will begin to see lower consumer spending and lower corporate earnings. The economy has plenty of legs and should enter Phase 3 next year. But stock prices will be under threat.
The housing bubble pop will show strongly at the end of the Summer and certainly in 2007. The Housing boom is responsible for ~40% of all job growth in the past 5 years, as well as the bulk of the GDP growth. When that carpet gets pulled out, the economy won’t trip – it will fall.
Against this background are stable growth, stable inflation, and some global growth. Dollar strength will lower commodity prices and oil, but that props up margins only so much (unless you are hugely impacted by imports or commodities – airplanes and trucking, for example).
I am therefore focused on markets that are still showing string growth and stocks that continue to have strong pricing power in those markets.
What is the business cycle? The idea that the basic economy moves in a 4 part cycle and that investing can succeed by following the cycle. Here is an approximate way to think about it:
Part 1 – Post recession. Manufacturing is picking up, consumer spending is still uncertain. Corporate fundamentals are stabilizing. Invest in equities. Avoid bonds.
Part 2 – Growth. Demand is strong across all sectors. Interest rates begin to rise. Invest in equities, finance stocks and commodities (companies begin to experience pricing power). Unemployment drops. Avoid bonds.
Part 3 – Coasting. People have bought what they need, interest rates continue to rise to moderate growth. Signs of oversupply and overinvestment begin to show. Unemployment continues to be low. Avoid commodities and start to shift away from equities and towards bonds.
Part 4 – Downturn. Demand is dropping. Interest rates begin to drop. Buy bonds.
As you can see, anticipating the next phase allows one to shift away from softening sectors and into ramping sectors.
I think that we are entering Part 3. Housing is slowing. Consumer durable purchases are slowing. Interest rates are slowing their rise. Commodity prices are starting to soften and consolidations are picking up (a basic way to leverage a cash stockpile and show additional profit growth).
Here’s a great chart of historical economic activity; it shows the biz cycle in action
http://jec.senate.gov/_files/ISM3Mar2006.pdf
Start with the blue line for manufacturing activity: it began slowing in 2000 until bottoming out in 2001. It drifted until 2003 and was strong for 2004. It remained stable and string in 2005 (though not nearly as strong as 2004).
2002~2003 – Part 1. Growth but not solid.
2004~2005 – Part 2. Solid growth. Demand for consumer durables and commodities surges.
Lets shift now to the numbers.
GDP Growth – In Q4 2005, GDP grew at its slowest rate in three years — 1.1%, which is down from 4.1% growth in the third quarter. (Here’s a great chart http://jec.senate.gov/index.cfm?FuseAction=Charts.Detail&Image_id=136)
Before we panic, look at that chart and you’ll see that Q4 is always the weakest quarter. Which makes sense – it’s the big shopping season and manufacturing and inventory buildup peaks in Q3 as retailers and producers stock up. Q3 2005 was quite respectable compared to Q3 2004.
First of all, Q3 was all about dealing with Hurricanes. That cooled as we moved into Q4. Second, consumer spending is slowing. Ummm, that’s exactly what we should expect to see: that’s what the Fed is driving towards. Housing and cars in particular dropped: two sectors sensitive to interest rates. But I think another factor is at work here: buyer exhaustion. Starting in 2001 and accelerating in 2002, consumers were invited to spend spend spend. New cars, new washing machines, new houses. People don’t need to replace all of this new stuff just 3 years later. Come on – did anyone expect this level of spending to continue???
As spending starts to slow, inventory buildsup: bingo! That happened in Q4. Next, excess inventory gets dumped and imports sag a bit.
That will hit earnings – highflying tech stocks will get hit as will any company selling consumer products with overly aggressive expectations. Earnings will grow at slower rates.
We want to find the products where prices are not dropping: Mobile entertainment and home entertainment, Titanium, healthcare.
Our 2006 approach should be that consumers are catching their breath in the 1st half (repairing their balance sheets, paying taxes) and then things will pick up in the 2nd half. We will begin to see lower consumer spending and lower corporate earnings. The economy has plenty of legs and should enter Phase 3 next year. But stock prices will be under threat.
The housing bubble pop will show strongly at the end of the Summer and certainly in 2007. The Housing boom is responsible for ~40% of all job growth in the past 5 years, as well as the bulk of the GDP growth. When that carpet gets pulled out, the economy won’t trip – it will fall.
Against this background are stable growth, stable inflation, and some global growth. Dollar strength will lower commodity prices and oil, but that props up margins only so much (unless you are hugely impacted by imports or commodities – airplanes and trucking, for example).
I am therefore focused on markets that are still showing string growth and stocks that continue to have strong pricing power in those markets.
posted by Andrew at
6:06 PM
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