This is MoneyClub

Stocks for the Long Run
Part 3: HOW THE ECONMIC ENVIRONMENT IMPACTS STOCKS

Chapter 12 Chapter Guide

Prelude

WHO CALLS THE BUSINESS CYCLE?

STOCK RETURNS AROUND BUSINES CYCLE TURNING POINTS

GAINS THROUGH TIMING THE BUSINESS CYCLE

HOW HARD IS IT TO PREDICT THE BUSINESS CYCLE?

CONCLUSION

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Chapter 12 Chapter Takeaways

Prelude
-Anecdote. Lesson: Markets and the economy are often out of sync. Many investors dismiss economic forecasts. HOWEVER: the market still responds powerfully to economic changes.
-Altho a market decline might not be followed by a recession, stocks almost always fall prior to a recession and rally on an impending recovery. If you can predict the business cycle, you can beat the buy-and-hold strategy. Wall Street loves this not because they are successful at it but because of the potential gains.

WHO CALLS THE BUSINESS CYCLE?
-The dating of business cycles is done by NBER, a private body founded in 1920 which keeps data back to 1854.
-Common definition of a recession = 2 quarters of negative econ. growth. However NBER actually uses 4 facotrs: employment, industrial production, real personal income, and real manufacturing/trade sales.
-Over the past 2 centuries, the 46 recessions have an average length of 19 months while expansions average 34 months. Since WW2, there have been 10 recessions, avg 10 mths, and expansions avg 66 months.
-NBER takes care not to make mistakes in calling the peaks and troughs, sometimes collecting data til 20 months after the fact.

STOCK RETURNS AROUND BUSINESS CYCLE TURNING POINTS
- Out of 46 recessions, 42 have been preceded by declines of 8% or more.
- Analysing the 10 post WW2 recessions, returns peaked anywhere from 0 to 13 months before a recession beginning.
- However, as Paul Samuelson noted, “The Stock market has predicted nine out of the last five recessions!” – lots of false alarms. False alarms have increased since WW2.
- Chapter 16 will discuss the 1987 stock crash and explain why it did not lead to an economic downturn, tho its decline of 35.1% is the largest in 200 years of stock returns data.
- The average lead time between a market upturn and an economic recovery has been 4.8 months, as compared to the average 5.7 months that peaks in market precede peaks in the business cycle.
- 2000 to 2002 bear market: Some controversy as to if there were 1 or 2 bear markets. Economic data supports 2.
- By the time the economy has reached the end of the recession, the stock market has risen 22.4% on average, so an investor waiting for tangible evidence that the cycle has hit bottom has missed a substantial rise.

GAINS THROUGH TIMING THE BUSINESS CYCLE
-Switching returns are defined as the returns to an investor who switches from stocks to bills a given number of months before (or after, if predictions ar enot accurate) a business cycle peak and switches back to stocks a given number of months before/after a trough. Buy and hold returns are the returns from holding the market thru the entire business cycle. Excess returns are defined as switching returns minus the returns from the buy-hold strategy.
-Results: it is more important to forecast troughs of the business cycle than it is peaks. Additionally, the maximum excess return of 4.8% per year is obtained by investing in bills 4 months before the busines cycle peaks and in stocks 4 months before the business cycle troughs.
- The long term impact of these gains can be impressive. Successfully predicting the above wil more than triple your wealth compared to buy and hold.

HOW HARD IS IT TO PREDICT THE BUSINESS CYCLE?
-The record is poor. Presidential economic advisors have called recessions 6 years ahead of time.
-Eggert and Moore compiled a summary of a panel of forecasts called Blue Chip Economic Indicators – anecdotes about BCEI was years off target during 1979-82.
-Much data to show how bad forecasters are.

CONCLUSION
-Stock values are based on corporate earnings, and the business cycle isa prime determinant of changes in these earnings. The gains of being able to predict the turning points of the economic cycle are enormous, yet doing so with any precision has eluded all economists. Despite the growing body of economic statistics, predictions are not getting much better over time.
-The worst course an investor can take is to follow the prevailing sentiment about economic activity. The reason is that it will lead the investor to buy at high prices when times are good and everyone is optimistic, and sell at the low when the recession nears its trough and pessimism prevails.
-The lessons to investors are clear. Beating the stock market by analyzing real economic activity requires a degree of prescience that forecasters do not yet have. Turning points are rareloy identified (by forecasters) until several months after the peak or trough has been reached. Byu then it is far too lat eto act in the market.