A variety of approaches to broad market analysis provide the trader with the ability to clarify his or her view with alternate tools. Additionally, there are occasions when the standard tools do not provide the insight one is seeking; at this time employing an alternate approach may help shed some light on why the market is unfolding as it is. While there isn’t a tool out there that guarantees future movement in the market, performing broad market analysis is a very important first step in evaluating potential trade strategies.

The blended approach to analysis discussed in this series (2006) includes three primary areas: fundamental, technical and sentiment. In July, fundamental analysis will include a look at the current business cycle to gain insight to broad market conditions. The technical view will include intermarket analysis, while the sentiment view

Business Cycle Declarations

The National Bureau of Economic Research [NBER] is the entity that declares the state of the business cycle, on a lagging basis. The most recent information from the group came in July 2003, announcing that a November 2001 trough ended the last economic contraction. One good thing the length of the lag provides is a convincing argument that the most recently announced peak or trough is accurate—it’s not going to be re-stated.

It’s easy to recognize that such data is not the sort an ultra-short term trader may use, but clearly the state of the business cycle has some market implications. It’s up to the analyst to gain insight by understanding typical trends in the cycle and monitoring the economic data that underlies the cycle. Next the individual needs to determine which groups generally perform better during the different phases of the cycle.

To back-up slightly, the business cycle is generally depicted as a sine wave that represents periods of economic growth, to contraction and back to growth again. The traditional definition for a recession (contraction period) is two or more quarters of declining Gross Domestic Product [GDP] data. NBER does not simply use GDP—income, employment, industrial production and wholesale-retail sales data are also incorporated into their research on a non-equal weighted basis to provide a more comprehensive view of the economy.

The cycle perpetuates because economic growth leads to increasing prices which ultimately slows growth to the point of a decline. In this decline, there is a fall in the cost of doing business (materials, wages, cost of money), which prompts growth. A nice symmetric wave pattern is not a realistic representation for the rates of expansion and contraction, but it does a good job of reminding us of the continuity of the cycle.

The chart that follows is similar to the wave-like business cycle representation in that it measures all expansions at a level of 1.0 and all contractions at a level of -1 (similar to a standard sine wave image). These are the spikes and “V’s” on the chart. Between NBER peak and trough announcements, data was added to provide continuous lines for the graph. The value of the “fill” data is dependent upon the number of months between extreme points—if there was a 10 month period between a peak and a trough, each data point represents a 0.20 segment [(1 – (-)1) / 10]. Focus on the extreme points; the objective is to note the changing periods between peaks and between troughs, over the 147 years the data has been provided.

Figure 1: Business Cycle Peaks & Troughs (1854 – 2001)

For reference, the grey vertical lines represent 10 year periods in the 147 year history. The period from approximately 1940 to 2001 is provided with more detail in Figure 2. Similar graphs for 1854 – 19191 and 1919 – 1945 can be found at the end of the article. Note the longer timeframe for recovery in the later portion of the graph.

Figure 2: Business Cycle Peaks & Troughs (1940 – 2001)

The extended recovery periods (expansions) are more easily seen with this graph, which provides the most recent business cycle data. For the most part, the contractions in this figure appear to be of similar duration. Again, keep in mind that the lines on the graph represent the time between peaks and troughs, not actual data for those months.

NBER breaks out business cycle metrics for three periods (Table 1) with the entire cycle lengthening in the third period. This lengthening is definitely attributable to longer recoveries, as the term for contractions declined successively in each period [from "Business Cycle Expansions and Contractions." NBER Website. Tuesday, July 11, 2006].

Table 1: NBER Business Cycle Metrics

Current Reports

Using the November 2001 low, we are currently 56 months into an expansion. This value is slightly lower than the average period for an expansion in the last 60 years, so it’s reasonable to look for signs of slowing. The table that follows provides monthly data from the St. Louis Federal Reserve Bank, Federal Reserve Economic Data (FRED®). The specific report and data period are identified, along with observed changes from the previous year and the previous month. The most volatile changes will occur month over month. While the year over year trends appeared to be positive, a flattening in more recent periods was observed in Real Disposable Income (moderate), Wholesale and Retail Sales.

Table 2: Various Economic Data Based on NBER Categories
 * Recent peak remains below current levels.
** Institute of Supply Management: PMI (formerly Purchasing Manager’s Index)

Based on economic reports using some similar data as NBER [that sounds nice and vague—just trying to point out it’s not NBER data], it appears the longer, less volatile view of the economy remains pretty healthy. It’s hard not to let the recent market slide or increasing prices impact this conclusion. We have to remind ourselves to use specific data to evaluate the cycle picture, not what we “feel” is happening in the economy. At this point, given the duration of the expansion, it is probably fair to say that we are in the later portion of it.

Sector Strength by Business Cycle Phase

As mentioned earlier, the business cycle is self-perpetuating. Economic weakness leads to lower prices later in the contraction for materials, people and money (low interest rates). This bargain environment ultimately prompts investment, which eventually leads to growth and early phases of recovery. The cycle itself will vary in both timing and strength—it’s not something we can set our watches or calendars by. However, by knowing general trends in the business cycle and monitoring both economic reports and various sectors, a tool is added to our broad market analysis. This will be discussed further next week in the intermarket analysis article.

According to Sam Stovall (Standard & Poor’s Guide to Sector Investing), the business cycle can be analyzed from a five phase view when considering outperforming equity sectors.¹ Since officially there is an expansion in place, let’s start there:

So if we are truly in the later stages of an expansion, we’d expect to see relative health in Basic Materials and Energy, with possibly some signs of life in the Consumer Staples and Utilities sectors. The charts for the Select Sector SPDR® exchange traded funds (ETFs) seem to confirm the late expansion to early contraction period we are entering. Although the Basic Materials group (XLB) has shown recent weakness after a nice ten month rise, the Energy group (XLE) continues to remain strong.

      
Figures 3a and 3b: Late Expansion Sectors

The Utilities group (XLU) is in a price consolidation, but has shown strength relative to the S&P 500 since late spring. Similarly, Consumer Cyclicals turned in late spring after a multi-year decline in relative strength. There may be something to Mr. Stovall’s observations after all.

Figures 4a and 4b: Early Contraction Sectors

Summary

Performing an analysis of the business cycle provides a big picture view of the economy. Since there can be significant lags in some of the data, it is not a market timing tool. Rather, it should be used as a means of identifying conditions that are beneficial or detrimental to different sectors and industries. As the economy shifts from early and late periods of expansion and contraction, signs of such shifts may be visible in different sectors and can be evaluated with a relative strength comparison of these sectors to a broad market benchmark.

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Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

¹ John Murphy, Intermarket Analysis Profiting from Global Market Relationships, [John Wiley & Sons, 2004]

Business cycle peaks and troughs for 1854 – 1919 and 1919 – 1945:

1854 – 1919

1919 – 1945

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