Investors should study and understand the relationship between three different cycles; economic, business and stock market cycles prior to making any investment decisions. These three cycles generally exhibit the same basic patterns of duration and direction, but with peaks and valleys at different points in time. The business cycle tends to peak first, as businesses report sale and profit numbers shortly after they are calculated. As business sales improve, the probability of improved profits are usually enhanced. Increased business activity has often been preceded by an increase in the money supply as a result of actions by the Federal Reserve Bank. Confirmation of the improvement in the business cycle is often validated by a subsequent drop in unemployment levels.
As chart patterns on business activity trend upward, consumer confidence tends to improve, resulting in a positive public perception of the stock market. There are three major engines for stock prices are: The first, and probably most important driver is improved corporate profits in conjunction with revenue increases. Profit improvement without revenue growth is not evidence of a dynamic and growing company. Once the investing public has the view that increased profits are at a sustainable price, the company's stock often improve. Second, stock price determinate appears to be a function of the stock market itself. As the number of stocks experiencing price increases expands investors become more enthused about investing. Increased confidence in the market tends to spill over to other companies resulting in price increases in their stock. Validation of this theory can be substantiated by comparing price performance of large capitalization issues (market price times shares outstanding equals greater than 5 billion dollars) to price performance of small capitalization stocks (less than 500 million in stock value). Once the market price of large capped stocks has peaked investors usually turn to the smaller cap issues and commence bidding the price of these lesser known companies higher. Third and final area that appears to drive stock prices is investor psychology. Investors hear about the potential of a stock through friends, newspapers or television and begin bidding the price of the stock up. There is usually little concrete logic behind this enthusiasm, quite often the price will collapse once investors become bored with the stock.
The last chart indicating overall improvement is one that tracks the economy itself. Graphs of business activity and the stock market have already reflected improvement and subsequently become input to the government's charts of economic activity. For example, reduction in unemployed is not possible until there has been increase in business activity followed by increased profits which is quite often followed an increase in stock prices. Thus, the last charts to diagram this improvement are those that tract the economy itself.
Duration of these charted cycles are by no means predictable but, recessions typically have a range of 6 to 18 months (with 1929 as the exception) and periods of relative prosperity generally have a range of 36 to 81 months (with 1982-1990 and 1990-2000 as exceptions). Periods of recession are often preceded by high inflation, high interest rates, increasing unemployment, declining gross domestic product and inverted yield curves. Periods of prosperity usually tend to be two to three times as long as a recessionary period. Investors should begin to understand the dynamics of this process and not be panicked by media hype. Modifications in a portfolio should be a result of changes in investor objectives, portfolio balancing or fundamental analysis.