Business Cycles and Equilibrium - Thesis Example

Business Cycles Introduction Asset price fluctuation in the market is influenced by various economic factors at various intervals. Therefore, a framework of asset allocation in a given segment can be crucial in analyzing the factors. Business cycle is a temporal segment of cyclical fluctuations in a few years or some months, and thus can reflect factors and trends of economic changes during this period. The changes of various economic factors including interest rates inflation and corporate earnings in the economy can act as a guide to identifying the various business cycle phases, including early (expansion), mid (propensity), late (contraction) and recession, prevalent in the market (Black 100). Generally, the business cycle phases are distinguished by various economic changes. These economic changes characterizing the cycles may include employment changes, interest rate changes and industrial productivity. Therefore, the business cycle can be referred to a pattern of fluctuation in the GDP (Gross Domestic Product) which affects employees, investors and employers. For instance, a business cycle significantly affects investors, employees and employers who work for a living in the production of services and products, which are in demand (Black 100). The demand for more products fuels inflation and at the same time wages increases. In due time, the demand for products and services decreases as consumers view the prices as unaffordable, this in turn forces the prices to decrease and causes recession. At the end of the cycle, the demand rises as a result of the declining prices as lower prices fuel demand. Therefore, the cycle starts at the beginning once again. When the business cycle is hugely affected by economic factors and does not run smoothly, it can result in the Great depression. Hence, this is the reason behind governments drive to intervene and manage economies (Piros & Pinto 284). Tracking the cycles assists experts in determining the direction and trends of the economy. The business cycle can be beneficial in the equity sector as it can track equity market returns over a given period from months to years (Black 100). The business cycle phases In a given period, the economic cycle may differ from one cycle to another; however, there are some trends, which are repetitive and thus are critical in analyzing the fluctuation in determining economic changes. The changes in the economic cycle are vital transformation in the rate of development in the market especially declining and increment in rates of growth in inventories, employment, corporate profits and credit. Even though some microeconomic trends may disrupt these changes in economic activities during cycles, historically the key changes have proven too vital in determining the phases of a business cycle (Piros & Pinto 284). A typical economic cycle has four distinct phases including the Early-cycle/expansion phase, prosperity/mid-cycle phase, contraction/ late cycle phase and recession phase as illustrated in the diagram below. Each of these cycles experience varying degree of changes in economic factors. The early cycle phase is characterized by recovery from an economy depression. The phase has an average rate of economic activity including employment, industrial production and GDP. The early phase indicates a potential growth in sales and credit due to undemanding monetary policies even though at this stage business inventories are at a low performance. Therefore, the economy is improving significantly at this stage (Pring 23). The prosperity phase, also referred to as the mid-cycle, is the longest of the four stages in the economic cycle. At this stage, there is a modest rate of increment in economic growth than the initial stage as the economic activity is gaining momentum more steadily. Profitability in business and the credit growth are healthy and strong, while the business sales and inventories are at equilibrium due to significant growth of the economy (Holt 56). The late cycle is characterized by intense economic activities as the economy is hindered by high inflation rate. The stage experience a stalling economic growth that is distinguished by a restrictive fiscal policy, declining sales and significant increase in inventories as well as deteriorating profit margins and lessening credit (Holt 56). The economy at this stage is moving towards a recession. Then the Recession period follows with a contraction in activities. The last stage sees scarce credit as business profits have declined notably. The fiscal policy at this stage is accommodative while the inventories face a decline amid low sale rates (Holt 56). Therefore, the distinctive factor of Business cycles is the trend in economic activities, which are helpful in assisting economic experts to manage and control the economy. The performance of assets including stock is generally strongest during the early stages but tend to drop significantly in the latter ones. This is due to the rapid growth in economy in the first stages as the latter stages experience faltering and declining growth due to a declining economy (Piros & Pinto 284). However, defensive assets including the Treasury bonds appear to gain momentum in the latter stages when the economy is declining while worst performance of these bonds is likely in the first stages of the business cycle (Brüggemann & Carstensen 5). Therefore, an economy recovery occurs when the economic determinants improve steadily over a given period while a recession (depression) is experienced when the same economic indicators have gone through a contraction. However, the cycle is not regular, the phases lack a specified set of intervals, and consequently economic recoveries and the phases may take months or years (Brüggemann & Carstensen 5). Performance patterns Since 1962, the performance of economic indicators like the equity market have experienced rotation due to the shift of the overall economy form one phase to the other in the economic cycle. This is due to the economic structural changes, differing regulatory policies, technology among other factors. Therefore, it is vital for investors to understand and note the outperforming sectors as well as those underperforming in order to make the right decisions in investment. Understanding the sectors to invest and those to avoid on the various stages of a business cycle is vital (Pring 101). From a historic point of view, the early phase of the business cycle experiences robust performance with steady improvement in economic indicators. The early phase always promises positive performance as in this stage, the top stock markets have resulted in good returns. Estimates indicate 24 % average returns each year in the early phase. Consequently, there are sectors, which generally benefit in the early phase due to the decrease in interest rates and economic improvement including financial and consumer discretionary sectors (Pring 23). Moreover, economic sensitive sectors like industrials, materials and information technology also benefit from the shift from recession to recovery phase. This is because these sectors partly depend on increased borrowing. The tech industry benefits from renewed expectations as corporate and consumer spending strengthens, and this boosts the industry’s prospects for a wide range of goods. However, the energy sector, utilities and telecommunication services lag in the recovery phase as they are characterized by a defensive nature due to persistent demand in all phases of the economic sector. Hence, these sectors have failed to perform in the market in the early stage of the cycle (Brüggemann & Carstensen 6). In the mid phase, economic sensitive industries continue to perform amid the moderate growth of the economy. However, a more positive performance is experienced in the sectors that see a peak in demand when the recovery is entrenched. Even though not to the same level of degree like in the first phase, stock market in the mid-cycle is moderately strong and generally are at 15%. Even though the magnitude of top performers of various sectors including energy, healthcare, financials, industrials and utilities have rotated frequently, Information technology sector has been the best performer in this stage (Brüggemann & Carstensen 6). According to history, the late cycle period usually lasts an average period of one year and a half. Annually, overall stock has averaged approximately 9% during the late cycle. As the recovery period matures, sectors including materials and energy have outperformed due to good prices in raw material that these sectors depend on. Consequently, defensive sectors like the consumer staples, utilities and healthcare have performed well. However, consumer discretionary and information technology stocks have lagged in this period as investors tend to avoid economically sensitive sectors (Pring 101). The recession phase usually lasts a shorter period, 10 months, in comparison to the other sectors. The recession phase experiences poor performance in many sectors. The broader performance of the sectors is estimated at an average of -14% annually. As the economic growth weakens and drops significantly, investors do not favor economic oriented sectors, and more defensive oriented sectors benefit during this period. The less economic-oriented sectors that benefit are utilities, telecommunication services, consumer staples and healthcare. During recession industries that produce electricity, toothpaste, drugs, phone services are at an advantage, as the regular consumer does not cut back on these products and services (Pring 101). Conclusion Therefore, the business sector approach is very beneficial in determining the economic direction of the market. Investors are more likely to benefit in decisions on investment by referring to the business approach rather than other methods like the NBER method. Investors who understand how the economy transforms have a better perspective on the economic indicators in the various phases of the cycle and thus can predict the economic trend of the economy. Work Cited Black, Ken. Business Cycles and Equilibrium. Hoboken, N.J: Wiley, 2013. Internet resource. Brüggemann, Ralf, and Kai Carstensen. Economic Forecasts. Stuttgart: Lucius & Lucius, 2011. Print. Holt, Charles A. Markets, Games, & Strategic Behavior. Boston, MA: Pearson Addison Wesley, 2007. Print. Piros, Christopher D, and Jerald E. Pinto. Economics for Investment Decision Makers Workbook: Micro, Macro, and International Economics. Hoboken, N.J: Wiley, 2013. Internet resource. Pring, Martin J. The Investors Guide to Active Asset Allocation: Using Technical Analysis and Etfs to Trade the Markets. New York: McGraw-Hill, 2006. Internet resource. Read More