Besides the long time period cycles that shift the centre of economic prosperity across the globe, each economy goes through phases of boom and burst regularly; these are of shorter duration and higher frequecy – commonly referred to as the Business Cycles.
Business cycles are a type of fluctuation in the aggregate economic activity. A cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general contractions; that is followed by general revivals, which lead to the expansion phase of the next cycle. This sequence of changes is recurrent but not regular. In duration business cycles vary from more than one year to ten or twelve years.
A recession occurs when a decline – however initiated – occurs in some measure of aggregate economic activity and causes cascading declines in the other key measures of activity. Thus, a dip in sales causes a drop in production, triggering declines in employment and income, which in turn feed back into a further fall in sales; a vicious cycle results and a recession ensues. This domino effect of the transmission of economic weakness from sales to output to employment to income, feeding back into further weakness in all of these measures in turn, is what characterizes a recessionary downturn.
At some point, the vicious cycle is broken and an analogous self-reinforcing virtuous cycle begins, with increases in output, employment, income and sales feeding into each other. That is the mark of a business cycle recovery. The transition points between the vicious and virtuous cycles mark the start and end dates of recessions.
Leading indicators are designed to anticipate the timing of the ups and downs in the business cycle. They are related to the drivers of business cycles in market economies, which include swings in investment in inventory and fixed capital that both determine and are determined by movements in final demand. They also include the supply of money or credit, government spending and tax policies, and relations among prices, costs and profits. An understanding of these drivers can help identify the predictors of the downturns and upturns.
An investor in equity needs to keep tab on these leading indicators, basically to regulate the timing of his invetsment. When the economy seems to lead to a recession, is the time to remain out of equity; to book profits and hold cash/debt. And then when the economy seems to be heading to a revival, is the time to begin entering equity once again. This may seem very sensible. But it is very difficult to practice, as the indicators are not always reliable. But one needs to keep this logic at the back of one’s mind.
Some right guesses, some wrong guesses, the net result should deliver a reasonable return. This is better than leaving the investment entirely to chance. And definitely better than doing exactly opposite – which is quite a common tendency : to dump equity when the economy is in dumps, and rush to equity when the economy is at the peak.
The other parameters that one needs to track are the macro-economic policy changes. The changes could be in fiscal policy, foreign trade policy, monetary policy, etc. Fiscal policy impacts the performance of individual companies in various ways. The fiscal policy determines the aggregate demand ad the general price level. This is a very delicate balance.
A lax fiscal policy may pump up demand by injecting purchasing power in the economy, but if that does not augment the supply fast enough, it will add fuel to the inflationary fire. Rising prices, leading to rising wages, then impact the production costs. Thus forces that initially seem to grow profit margins end up squeezing them. Monetary policy has similar effect on the equity market, though the easing and tightening of liquidity.
Tax policy, depending upon the nature of cahanges, has impact on both the economy as a whole as well as on individual industries. Therefore a careful impact analysis of tax changes gives a clue to the threats and opportunities in the equity market.
Before we conclude let us take a peek into the art and science of constructing and managing a portfolio of equity shares. To keep it simple to start with, let us begin with a portfolio of just two shares A and B. It is possible to construct a series of portfolios with different risk/return characteristics just by varying the weights of the two shares in the portfolio. Let us asume that shares A and B have a correlation coefficient of H and the following individual return/risk characteristics :
If proportion of the two shares in the portfolio is K and L respectively, then the portfolio return (P) is given by P = (K x C) + (L x D) (the weighted average of the returns from the two shares), and the portfolio risk (Q) is given by Q = √ {[(K)2 x (E)2] + [(L)2 x (F)2] + [2 x K x L x H x E x F]}.
In simple words, while the portfolio return is the the weighted average of the returns from the two shares, the portfolio risk is not the weighted average of the risk from the two shares. Portfolio risk would be (to put it simply but not very accurately) more than the weighted average of the risk from the two shares, if the returns from the two shares are positively correlated; and it would be less than the weighted average of the risk from the two shares, if the returns from the two shares are negatively correlated. This means, you cannot effectively increase the return by creating a portfolio of shares (instead of holding a single share), but you can reduce the risk. And the key to reduction of risk lies in picking shares whose returns are not positively correlated.
Once you increase the number of shares in your portfolio, a number of efficient portfolios ae possible : portfolios that give the highest possible expected return, at a given level of risk. It is up to you to choose which of these you would like to hold.
