Rahim Panjwani in Opinion December 27, 2002 6 Views

Increased jobless claims and shrinking economic output. How does this affect us as investors? What does a jobless person have to do with my portfolio? What does shrinking output have to do with my blue chip shares? Well, all these indicators are part of a larger picture determining the strength of the economy and identifying whether or not we are in a period of recession or expansion.

But, in order to understand what state an economy is in, we first need to take a good look at the business cycle as a whole. Generally, the business cycle is made up of four different periods of activity extended over several years. These phases can differ substantially in duration, but all are closely intertwined in the overall economy.

Here are the four phases:

Peak – This is not the beginning of the business cycle, but at this point, the economy is running at full steam. Employment is at or near maximum levels; GDP output is at its upper limit (implying that there is very little waste occurring); and income levels are increasing. In this period, prices tend to increase due to inflation; however, most businesses and investors are having an enjoyable and prosperous time.

Recession – The old adage “what goes up must come down” applies perfectly to this situation. After experiencing a great deal of growth and success, income and employment begin to decline. As our wages and the prices of goods in the economy are inflexible to change, they will most likely remain near the same level as that found in the peak period unless the recession is prolonged. The result of these factors is negative growth in the economy.

Trough – Also sometimes referred to as a depression, depending upon the duration of the trough, this is the section of the business cycle when output and employment bottom out and remain in waiting for the next phase of the cycle to begin.

Expansion/Recovery – In a recovery the economy is growing once again and moving away from the bottoms experienced at the trough. Employment, production, and income all undergo a period of growth and, overall, the economic climate is good.

If graphically drawn peak and trough are merely flat points on the business cycle at which there is no movement. They represent the maximum and minimum levels of economic strength respectively. Recession and recovery are the areas of the business cycle that are more important to investors because they tell us the direction of the economy.

To further complicate matters, not all business cycles go through these four steps sequentially. For instance, during a double dip recession, the economy goes through a recession followed by a short recovery and another recession without ever peaking.

Recession vs. Expansion

Loosely measured, recession is determined by a decline in GDP output. This definition can obviously lead to situations where there are frequent switches between a recession and expansion, and, as such, many different variations of this principle have been used in hopes of creating a universal method for calculation.

In USA The National Bureau of Economic Research (NBER) is an organization that is seen as having the final word in determining whether or not the United States is in recession. They have a more extensive definition of recession, which deems the following four main factors as the most important for determining the state of the economy: employment, personal income, sales volume in manufacturing and retail sectors, and industrial production. By looking at these four indicators, economists at the NBER hope to gauge the overall health of the market and determine whether or not the economy is in recession or expansion.

The tricky part associated with trying to identify the state of the economy is that most indicators are either lagging or coincidental rather than leading. When an indicator is “lagging” it means that the indicator only changes after the fact. That is, a lagging indicator can confirm that an economy is in recession, but it doesnt help much in predicting what will happen in the future.

What Does This Mean For Investors?

Understanding the business cycle doesn’t matter much unless it helps the performance of our portfolio. What’s an investor to do during recession? Unfortunately, there is no easy answer. It really depends on your situation and what type of investor you are.

First, remember that a bear market does not mean there are no ways to make money. Some investors take advantage of falling markets by short selling stocks. Essentially, an investor who sells short profits when a stock declines in value. Problem is, this technique has many unique pitfalls and should only be used by more experienced investors.

Another breed of investors uses recession much like a sale at the local department store. Referred to as “value investing,” a follower of this technique looks at a fallen stock not as a failure, but as a bargain waiting to be scooped up. Knowing that better times will eventually return in the economy, value investors use bear markets as buying sprees, picking up high quality companies that are selling for cheap.

Finally, another type of investor barely flinches during recession. A follower of the long-term (buy-and-hold) strategy knows that short-term problems will barely be a blip on the chart when taking a 5-10 year horizon. This investor merely keeps on rupee cost averaging in a bad market the same way as they would in a good one.

Of course, many of us don’t have the luxury of having a 10-year horizon. In the same light, many investors don’t have the stomach for riskier techniques like short selling or the time to put into analyzing stocks like a value investor does. But that’s not the point. The important thing to realize is these are three positive ways of looking at a bad market. The key is to understand your situation and then pick a style that works for you. For example, if you are close to retirement, the long-term approach definitely is not for you. Instead of being at the mercy of the stock market, diversify into other assets such as bonds, the money market, real estate, etc.

The financial media often takes-on a sky is falling mentality when it comes to recession. But the bottom line is that recession is a normal part of the business cycle. I cant tell you what the best course is for you – that’s a personal decision. I can, however, summarize this article by saying that understanding both the business cycle as well as your individual investment style is key to surviving a recession.

Rahim Panjwani completed his articleship from KPMG Taseer Hadi Khalid & Co. and qualified for ACA in 2000. In addition to being an ACA, Rahim is a qualified APA from PIPFA (1998) and CIA from the IIA (2001). He has also successfully completed a training course on Management Auditing from London School of Economics. His past work experience includes working with Hongkong Shanghai Bank and Serena Hotels. Presently, Rahim is engaged with The Aga Khan University Funds Management & Corporate Affairs Department. He is a regular contributor of articles in Dawn, Business Recorder and News. He can be contacted at anoosha@akunet.org

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