During the phases of the business cycle, inflation, housing starts, consumer credit, auto sales, etc., have a tendency to follow a general historical trend. Assuming there is some relationship between economic activity and stock prices, in this post we'll examine a few of these tell-tale signs and discuss how they may lend insight into the future stock price movement. Of course, a brief post is clearly insufficient to cover such a vast topic such as this, but it may prove beneficial to focus on a couple of keys in the process. Let's begin by defining the business cycles and discuss how certain economic measures tend to trend during the different stages of the cycle.
The business cycle has four phases:
- Expansion
- Peak
- Contraction
- Trough
Most recently, the cycle hit bottom (trough) in the U.S. in mid 2009 and has been slowly expanding since then. However, this expansion is historically weak as compared to the majority of past expansions. During this recovery, GDP has struggled to surpass 2.0%. GDP is officially published three times after each calendar quarter. The second time (i.e.; first revision) for Q1 2013 was 2.4%. However, in late June it was revised downward to its final figure of 1.8%.
When the economy is expanding, it's common to find housing starts trending higher, along with consumer credit and auto sales. In short, an increase in economic activity begets economic expansion which begets more lending which begets more sales which results in increased corporate profits, which are critical to higher stock prices. Also, during periods of expansion, demand and sentiment rises and inflation often declines, at least initially. Recently, consumer sentiment fell slightly which coincides with the downward revision in Q1 GDP.
The difficultly in forecasting the future of stock prices lies partly in knowing what stock investors will buy based on what they believe is going to happen, which is essentially an educated guess. For instance, if investors believe economic growth is about to rise sharply, they would buy heavily and stocks would rise accordingly. Then, when reality arrives, if they've guessed correctly, absent any other catalysts, stock price movement may be somewhat subdued as the positive news would've already been priced in. However, if their guess were wrong and the economy contracted, and especially if the contraction were severe, stocks would fall hard. Part of the reason for this is that stocks would've risen sharply based on the good news and, hence, would have even farther to fall.
