LEVEL: BEGINNER
Recessions and Economic Slowdowns
The economy goes in cycles of boom and bust. While some economic theorists suggest that the pattern is more or less regular, just about no one agrees on how long those cycles actually are. But most do agree that modern capitalist economies function on a boom-bust pattern of expansion and contraction based on a variety of events, momentum, and structural changes in the ways societies are organized.
The moments of economic contraction are usually sustained periods of economic difficulty that manifest themselves in negative GDP growth, high or rising unemployment, lowered inflation or actual deflation, and low or negative income growth for most workers.
In the past sixty years, there have been eight major recessions:
* 1959-1960
* 1969-1970
* 1974-1975
* 1979-1980
* 1990
* 2000-2001
* 2007-2009
In each of these periods, the American economy suffered from slowdown with wages either stagnating, falling, or rising substantially slower than in other periods of better economic activity.
Like economic slowdowns, moments of high growth come and go and are often referred to as “bubbles” of some sort, like the web bubble of the late 1990’s or the housing bubble of the mid-2000’s. Like all bubbles, these popped and resulted in a period of recession and economic hardship. The most recent, from 2007-2009, was one of the worst financial crises of the 20th century and the impact of the downturn in terms of consumer demand is still a challenge for investors and business owners, even if the recession is technically over.
Cyclical Demand and the Consumer
This type of economic cycle is important to traditional long-only investors because they ultimately depend on consumption as the engine for their investment profits. If consumers are earning less, they will spend less, and the companies who sell to these consumers will make lower profits, which will in turn lower their stock values and might even threaten the future of the company. This is one reason why macroeconomic cycles are watched closely by every type of investor.
Types of Cyclical Stocks
Most American stocks are in businesses that cater to the American consumer, and they are cyclical in one form or another. Most cycilcal stocks focus on retail buisness, although they span several sectors. Companies that sell clothing, airlines and hotel chains, restaurant brands, car manufacturers, and financial companies specializing in consumer-oriented financing are all examples of cyclical stocks. Of the 17 companies on the NYSE that have a market cap over $150 billion, 13 could be classified as cyclical stocks (T, CVX, XOM, GE, IBM, JNJ, PFE, PM, RDS.A, KO, PG, WMT, WFC).
To understand the difference more clearly, let’s take a look at Wells Fargo (NYSE: WFC) and Citibank (NYSE: C). While both are famous banks, Wells Fargo has expanded its domestic mortgage operations aggressively in recent years, while Citibank has diversified its operations abroad and in more exotic types of investments like secondary bond markets and credit default swaps. In the past year, Wells Fargo overtook Bank of America (NYSE: BAC) as the largest mortgage provider in America, while Citibank’s American operations have shrunk slightly.
The Impact of Cycles on Cyclical Stocks
At the same time, America’s economy has recovered as foreign economies struggle and exotic investment markets see low volumes and less investment opportunities. The results for WFC and C are pretty obvious.
We see that WFC has largely appreciated as the American economy improves and C has struggled because it isn’t as heavily invested in the domestic mortgage market (which is growing rapidly) because of its bets on foreign investments (which have faced difficulties lately).
If you understand the impact that economic cycles and consumer demand has on a cyclical stock, you can time your investments in ways that will maximize yield and minimize loss. This is why the best investors research not only the companies they buy, but also the economies around those companies and how changes in individual consumer activity reflect the future potential of the market to rise or fall.