Chapter 1: Business Cycles

Economic Indicators

- Analysts make judgments about where in the business cycle the economy is by examining various economic indicators. Economic indicators are statistics that summarize different aspects of the economy. - The unemployment rate, the Consumer Price Index (CPI), and the gross domestic product (GDP) are all economic indicators. Economic indicators are used to assess the future, current, and historical performance of the economy.

Peak

- As the economy reaches full employment, it hits a maximum point of economic activity called the peak. The peak, the second phase in the business cycle, marks the end of the expansion phase and the beginning of the third phase, called contraction.

Business Cycles

- Fluctuations in the market - Includes 4 phases: expansion, contraction, trough, and peak

What are leading indicators of contraction/expansion?

• Business inventories (Growing inventories signal a contraction, because businesses are not selling their inventory as quickly.) • Initial claims for unemployment (An increase signals a contraction, decrease signals expansion) • New manufacturing orders for consumer goods (An increase signals an expansion, decrease signals contraction) • Building permits (An increase signals an expansion.) • Inflation adjusted money supply, as measured by M2 (An increase signals an expansion, decrease signals contraction) • Liquidity spread—spread between short-term and long-term interest rates (A narrowing signals an expansion, widening signals contraction) • Performance of the S&P 500 (An increase signals an expansion, decrease signals contraction) • Index of consumer spending (An increase signals an expansion, decrease signals contraction) • Consumer confidence (An increase signals an expansion, decrease signals contraction)

What are some important lagging indicators?

• Consumer Price Index (CPI) • Business spending • Unemployment report • Prime rate charged by banks • Bank loans outstanding • Employment Cost Index (ECI)—monthly changes in employee wages and benefits

What are some important coincident indicators?

• Gross domestic product (GDP). GDP measures the dollar value of all the finished goods and services produced within the geographic boundaries of a country. The Bureau of Labor Analysis has divided the GDP into four major components. • Gross national product. GNP measures production by the residents of a country; in other words, with GNP the question is who produces it, not where it is produced. • Foreign trade deficits. A decline means exports are growing faster than imports, indicating an expansion phase. • Non-farm payroll. An increase in hours worked and hourly wages across the country indicates an expansion phase. When the non-farm payroll decreases, the Federal Reserve may loosen the money supply to stimulate job growth. • Producer Price Index, or PPI (Increase in the price of materials and wholesale goods indicates inflation.) • Personal income levels (Increase indicates expansion phase.) • Retail and manufacturing sales (Increase indicates expansion phase.)

What are some important leading indicators?

- Housing starts is the number of new construction projects that have begun in the last month. During a recession, new construction slows considerably. When a family believes that they can invest in a new house or a business believes it can invest in a new building, this is an indication that economic confidence has improved, and it may be a signal that the recession is ending. Business inventories (Growing inventories signal a contraction, because businesses are not selling their inventory as quickly.) • Initial claims for unemployment (An increase signals a contraction.) • New manufacturing orders for consumer goods (An increase signals an expansion.) • Building permits (An increase signals an expansion.) • Inflation adjusted money supply, as measured by M2 (An increase signals an expansion.) • Liquidity spread—spread between short-term and long-term interest rates (A narrowing signals an expansion.) • Performance of the S&P 500 (An increase signals an expansion.) • Index of consumer spending (An increase signals an expansion.) • Consumer confidence (An increase signals an expansion.)

Recession v. Depression

- If the contraction phase lasts more than two quarters (six months), the economy is considered to be in a recession; - more than six quarters (18 months) is considered a depression.

Expansion

- Increase in economic activity and above average economic growth - In this phase, the production of goods rises and unemployment falls. - Credit is available because banks believe businesses and people will be able to repay their loans. - Available credit means lower interest rates, which fuels expansion, resulting in more jobs. - The expansion phase feels good to the average person, because jobs are plentiful and wages rise. - A risk of the expansion phase is the possibility of inflation, because increasing wages and available credit tend to boost prices.

Non-Cyclical Stocks

- Non-cyclical stocks do not significantly respond to changes in the economy. These companies produce goods and services that people need, in good times and bad. - They include tobacco, non-alcoholic beverages, pharmaceuticals, toothpaste, toilet paper, food, and utilities, such as water and electricity. Timing is less important for the buying and selling of these types of stocks, because they are less dependent on the phase of the business cycle. - For this reason, non-cyclical stocks are also called defensive stocks, because they provide more stable earnings and dividends during the various phases of the business cycle.

Contraction

- Perhaps inflation has caused consumers to reduce their spending, or perhaps production has exceeded demand for products, and business inventories have begun to pile up. - Either situation will trigger a reduction of employment and production. - During a contraction, the economy experiences a decline in economic activity. - Credit is usually tighter because banks are not as confident that loans will be paid back.

Cyclical Stocks

- Stocks whose performances track the ups and downs of the business cycle are called cyclical stocks. When the economy is expanding, these stocks do well, but when the economy is contracting, they do poorly. - These are the types of companies that benefit when consumers have extra money. - They include autos, specialty retail, home furnishings, apparel, and air travel. Cyclical industries include residential housing, travel, airlines, and auto manufacturing.

Housing Starts

- The most important leading indicator - Housing starts is the number of new construction projects that have begun in the last month. - During a recession, new construction slows considerably. When a family believes that they can invest in a new house or a business believes it can invest in a new building, this is an indication that economic confidence has improved, and it may be a signal that the recession is ending. Once building permits have been granted and new projects begin, builders buy materials and hire new workers, which lead to increased manufacturing and employment. - Thus, an increase in housing starts is a good indication that a contraction phase may be ending. - Conversely, a downturn in housing starts can indicate the beginning of an economic decline and possibly the onset of a contractionary period. When faced with a reduction in housing starts, the Federal Reserve may lower interest rates in an effort to make borrowing money less expensive to businesses and potential homeowners.

What are the 4 components of GDP?

1. The largest component, at around 70%, is personal consumption expenditures, which consists of all consumption goods and services sold within the U.S. 2. The second component is business investment, which consists of purchases by companies to produce consumer goods. These include new business equipment, inventory orders, and housing construction. 3. The third component is government spending, which is about 20% of GDP. 4. Imports and exports are the fourth component of GDP. Exports add to the GDP, while imports subtract from GDP. GDP is the statistic that is most commonly used for identifying business cycles and for determining whether the country is in a recession or depression.

What might be the best sign that the economy will show future expansion? A. Rise in PPI B. Rising CPI C. Reduced initial claims for unemployment D. A widening credit spread

Answer: C Explanation: Reduced initial claims for unemployment is a leading indicator, and when initial claims for unemployment drop, this is an indication that the economy may be on the verge of expanding. Rising PPI and CPI are better indicators of inflation and an overheated economy. A widening credit spread indicates a contraction of lending and is a leading indicator of a coming contraction.

Coincident Indicators

Coincident indicators are statistics that change at the same time as the economy changes. In other words, they reflect where the economy is right now. Thus, coincident indicators are used to identify the actual peaks and troughs of the economic cycle.

Consumer Price Index (CPI)

Consumer Price Index (CPI). The CPI is a monthly report released by the Bureau of Labor and Statistics. It measures changes in the price of a "basket of goods" that a typical consumer might purchase, including food and energy products. The CPI is considered the best measure of inflation. The release of the CPI has a large effect on both the equity and debt markets, because it gives a strong indication of whether the Federal Reserve will alter interest rates.

Lagging Indicators

Lagging indicators reflect changes in the economy that have already occurred. For example, the Department of Labor's unemployment report is a lagging indicator because employers lay off employees after a downturn has already begun.

Leading Indicators

Leading indicators are statistics that anticipate a change in advance of the economy as a whole. For the exam, leading indicators are the most important to know, because they have predictive power, and therefore, allow economists to tell us what the economic future may hold.

What is the key difference between GDP and GNP?

Remember, GDP = what is produced in one year in a specific place. GNP = what a group produces in one year, no matter where that took place, and that production includes any profits that group gains from their ownership of any assets

Trough

When the economy reaches its lowest point, it is in the fourth phase, which is the trough. The trough marks the end of the contraction phase and the beginning of another expansion phase.