'Fancy talk' broken down for everyday Aussies wanting to invest: 'Wish I knew'

Investing can be daunting, but it can help if you're better across the business cycle.

The economic cycle describes and visualises the process of the economy going through the four major cyclical phases: expansion, peak, contraction and trough. In layman’s terms, that’s fancy talk for trying to predict if you are coming out of a recession or heading towards a recession.

Although it may not feel like it, the economy is always in between recessions, so you may want to know how close we might be to the next one, and the cycle helps identify that for you – or at least helps give you an idea. But it is not a crystal ball.

The economic cycle is one of the most influential forces in the share market.

It is significant because it plays a large role in determining corporate profits, which is probably the most important factor that influences share prices.

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Share-market sectors are sensitive to different stages of the economic cycle. Some sectors may outperform when the economy is growing, while others may outperform when the economy is declining or in a recession.

Many professional investors make a living by rotating in and out of the various asset classes as they anticipate a change in the cycle.

You may not want to be that hands-on with your investments, but let me hit on the main points briefly because this is something I wish I had been taught 20 years ago when I started investing.

In order to see where we are in the economic cycle, it helps to pull up the current performance of the major three types of assets that are traded in markets all around the world:

• shares (equities)

• commodities (i.e. anything like produce, oil, precious metals, agriculture, gold and silver)

• and bonds (fixed income).

Stage 1

When the economy is entering into a recession or might be in a recession and has fallen from expansion (growth) into contraction territory, you might be able to identify this if you look up the performance of those three asset classes.

If bonds are doing well, and shares and commodities are doing poorly, this is a sign we are heading towards a recession.

This happens because bond prices rise as interest rates decline. Therefore, economic weakness favours a loose monetary policy and the lowering of interest rates, which is bullish for bond holders.

Stage 2

Here we see the bottom of the trough and the lowest point in the contraction phase of the cycle.

This typically also aligns with the bottoming of the share market’s decline.

Even though economic conditions have slowed or stopped deteriorating, the economy is still not in the expansion phase and might not actually be growing in terms of gross domestic product (GDP).

But the share-market is forward looking and might anticipate the expansion phase by bottoming before the economy actually does.

In stage 2, shares join bonds in the positive performance while commodities are still negative.

Stage 3

As the economic recovery gathers momentum, shares, bonds and now commodities join the positive performance party.

This starts with a preparation into the expansion (growth phase) of the economic cycle.

Typically, at this point the news might start asking things such as, ‘Is this the bottom or a false bull trap for the shares market?’

Stage 4

This marks a period of full expansion.

Stocks and commodities are in full-steam-ahead mode, but bonds begin to turn lower because when the share-market and economy are booming, fears of inflation start to rise as well putting pressure on the bond markets.

To fight inflation, federal banks begin to raise interest rates.

Stage 5

The peak.

Not all peaks are created equal though. Some peaks are a bubble.

Some are a ‘black swan event’ (black swan is an event rarely seen yet has disastrous effects.

This was made popular in a book of the same name by investor Nassim Nicholas Talib).

And some peaks are just normal expansion into contraction, like a needed nap for the economy.

In stage 5 we are officially in an expansion phase, albeit at the end of it. The economy will be growing at a slower rate, and interest rates will be rising.

Shares anticipate this decline by peaking before the expansion in the economy actually ends (remember: shares are forward-thinking). Commodities will be good performers, while shares and bonds will not be.

Stage 6

The last phase before starting over again, stage 6 marks the deterioration in the overall economy as the business cycle prepares to move from an expansion phase to a contraction phase.

Shares have already been moving lower during this time, bonds have been low for two phases and now commodities join the poor performance in anticipation of decreased demand from the economy slowing.

Sometimes we forget that the economy runs on all sorts of commodities: from copper and lumber to build houses, to gold and silver for telecom networks, and even cattle and pork products for food. When the economy slows, the prices of these commodities fall. Then it starts all over again.

Edited extract from The quick start guide to investing: Learn how to invest simpler, smarter & sooner by Glen James & Nick Bradley (Wiley $32.95), available at all leading retailers.