The economy has definitely been slowing. Some economists, including many who appear on the popular news shows, are predicting the next great depression. But the consensus is that it will be a short, shallow recession during the first half of 2008 with a recovery starting by this fall. Some economists think the current slowdown won't even be an official recession. But there is no denying that these problems ended the bull market that we experienced between January of 2003 and October of last year.
 
The Market Cycle

The stock market is cyclical. It goes up, peaks, goes down and then bottoms. When one cycle is finished, the next begins. The problem is that most investors forget to expect the end of the current market phase. The other challenge is that, even when you accept the existence of cycles, it is nearly impossible to pick the top or bottom of one until after the fact. That is what makes trying to time the market so difficult.

The S&P 500 has dropped over 20% from its high on October 11, 2007 to its recent low on March 17, 2008. This fits the classic definition of a bear market, which is a decline in stock prices of 20% or more over a period of at least two months. Bear markets are a normal part of the market, but how bad they will be depends on what causes the downturn, and the government's response to it.

The current problems in the economy are not simply due to a normal turning of the business cycle. They come from a financial crisis, which can potentially be much worse than a normal downturn. Falling home values and higher consumer prices, combined with the credit crunch could trigger a recession much worse than the normal slump. The main question is if the government's response to these problems, particularly the actions of the Federal Reserve, have their intended effect of minimizing the damage to the economy and allowing it to recover in a relatively short time.

Bear markets that are set off by economic shocks can be severe. Pessimists need only point to the Great Depression in the 1930s, stagflation during the oil crisis in the 1970s, and the collapse of real estate in Japan in the 1990s. These economic shocks meant terrible stock returns for years. While you can always find similarities between these big shocks and the subsequent economic downturns, the situation today is different from any of these in one important respect.

Extended bear markets tend to occur when share prices are overvalued to begin with. Blue chip stocks had an average price/earnings (P/E) ratio over 30 in 2000, just before tech and growth stocks collapsed. The historical average would be a P/E ratio of about 24. When the market topped in October 2007, blue chip stocks were trading at an average P/E ratio of less than 20, which would suggest we may be in for less pain this time.

There are never any guarantees when predicting how the stock market will perform, but it seems like the worst of the damage to stock prices has already been done. Blue chip stocks are now at historically low P/Es, and growth stocks are the cheapest they have been in more than a decade. These are not valuations that would normally presage further large drops in stock prices for an extended period of time. But how likely is it that the market will go up when it looks like we are just entering a recession? 

Trying to Time the Market

To qualify as a recession, the economy has to actually shrink for at least six consecutive months. It is true that stocks tend not to do well during a recession, as earnings fall and P/Es adjust. Many people try to time the market using economic conditions as a signal. They remain fully invested in stocks when the economy is expanding, and move their money into cash (bonds, money markets, and CDs) when the market is contracting. However, logical as it may seem, using such an investing system would be a mistake.

Even if you correctly forecast what will happen to the economy, investing on that information is not easy as it would seem. The truth is that stock prices do not necessarily fall during a recession. Prices in the stock market incorporate the collective expectations of the participants, and people invest based what they think will happen in the future. During the 11 recessions identified by the National Bureau of Economic Research from 1945 through today, the stock market rose seven times and fell four times, with the average stock market return during these 11 recessions being 3.0%.

So what would have happened if you correctly forecast the beginning and end of the last four recessions and tried to time the market based on that information? To find out, I did a test with two accounts starting with $100,000 of capital on January 1, 1980. The first account stayed 100% invested in the S&P 500 through July 1, 2007. The other moved to 100% cash at the start of each recession and back to 100% equities at the end.

After 27 years the buy and hold account ended with a final value (including reinvested dividends) of $8,177,881. The market timing account finished with a final value of only $6,991,663, more than a million dollars less (and interest rates during the first three of those recessions were between 8-15%, much higher than the rates available today).
If you still have doubts about the market's ability to turn in impressive short-term gains during a recession, consider the Great Depression. Between the high in September 1929 and the low in 1932, there were several market rallies, including one where the Dow Jones Industrial Average rose 50%.

During the period that was used to compare the buy and hold strategy with the market timing one, from January 1980 to today, there were four recessions which averaged 9½ months in length. When you are talking about that short a time period, all it takes for the stock market to start rising during a recession is for investors to look forward for a longer period, and anyone who focuses on forward 12-month earnings does that. Since 1945, economic recessions have been of such short duration that by the time a majority of forecasters are convinced the economy is in a recession, it means it is probably time to start looking for bargains in the stock market.

For your long-term investments, it seems clear that you are better of following the buy and hold strategy than try to follow time the market using a forecast of the economy. For your shorter-term trading there are some useful things you can do based on your knowledge of how the economic and market cycles work, including being able to identify what sectors of the economy should out- and under-perform the market as a whole.

The Economic Cycle and Sector Rotation

While the credit crisis began last year and may have peaked, the consumer crisis is just beginning. Consumer spending is by far the largest component of the US economy, accounting for roughly 2/3 of all spending, so when consumers stop spending the recession begins. Consumers still spend money of course, even during the worst depression. But in tough economic times they tend to buy mostly what they need and less of what they would like to have. As the economy improves, they begin to spend more freely. This affects how different sectors of the economy perform. 

Companies making consumer staples such as food, drinks, medicine and other basics tend to weather an economic downturn better. Discretionary spending on things like cars, jewelry, restaurants, vacations and other things that are "nice to have" get pushed to the bottom of the list. This means that different sectors are stronger at different points in the economic cycle. Naturally, there is a way to try to take advantage of this.

Sector rotation is an investment strategy that involves moving you investments from one industry sector to another in an attempt to beat the market. By dividing the business cycle into stages, it becomes apparent which are the historically successful periods for stocks in certain business sectors. With this general outline in mind, traders can try to judge what stage of the economic cycle we are in and then anticipate which companies will outperform the market, and which will tend to do the worst.

Figure 1 shows the various sectors of the economy and at what stage of the economic cycle that they have historically outperformed the market as a whole. Notice that this graphic also incorporates the relationship between the market cycle and the economic cycle we discussed earlier, where financial markets attempt to predict the state of the economy from three to six months into the future.

Figure 1: Market Cycle | Economic Cycle | Sectors

Let's go through each of the four stages of the economic cycle, looking at what is happening at each stage and what sectors tend to perform best. Keep in mind during this exercise that the market is anticipating the future. For example, as the economy is in the worst of the recession, the market may already be looking ahead to the recovery.

When the economy is in full recession we are at the lowest point, or trough, of the economic cycle. It is not a good time for businesses or the unemployed. It means GDP has been declining for several consecutive months, interest rates are falling, consumer expectations have bottomed and the yield curve is normal. The sectors that tend to profit most in this stage include Financials and Transportation near the beginning with Technology and Capital Goods doing well through the middle to end of this stage.

Once you enter middle recovery, the economy has begun to pick up. Consumer expectations are rising, industrial production is growing, interest rates have bottomed and the yield curve is beginning to get steeper Successful sectors are Capital Goods near the beginning, Basic Materials, and Energy from the middle to end of this stage.

As the economic expansion matures, you hit the peak of the economic cycle. Interest rates can rise rapidly with a flattening yield curve. Consumer expectations will begin to decline, and industrial production is flat. The sectors that perform best in this stage include Energy and Basic Materials near the beginning. It is during the later part of this stage that Consumer Staples and Healthcare, traditionally known as “defensive sectors” do well. That does not necessarily mean they will rise as the market starts to decline in value. Outperform can simply mean that they decline less than the market as a whole. 
The last stage of the economic cycle, and the one that many believe that we are in today, is middle recession. This is when things start going bad for the economy after a long period of good times. Consumer expectations are at their worst and industrial production is falling. Interest rates are at their highest and the yield curve is flat or even inverted. The sectors that typically do well during these rough times are Utilities near the beginning, with Consumer Cyclicals Financials, and Transportation near the end.

The table below summarizes what typically happens to consumer expectations, industrial production, interest rates and the yield curve during each of these stages

Conclusion

Understanding how the Market and Economic Cycles work gives you a framework to work with when developing your overall investment strategy. Knowing which sectors are most likely to out- and under-perform allows you to out the odds in you favor when determining how to allocate your investments. It will also help in your short-term trading, allowing you to make sure your bullish trades are in the strongest sectors and bearish trades are in the weakest sectors.

If you can try to think in the long-term you will find that the outlook for the stock market isn't that bad and may even be mildly encouraging. Since stocks typically recover several months ahead of the economy, we are probably near the bottom of this market cycle, despite the fact that the economy itself may have a lot more bad tidings in store.