Permanent Value

Investing in Good & Bad Economic Times

Bruce Doole
August 17th, 2009

In the most recent newsletter we talked about how important it is to keep in mind the current economic cycle.  In this newsletter, we will describe in more depth what happens when we’re in each cycle and what type of investments are uniquely suited for them.

The Economic Cycle

Recession: Past the economic peak.   Weaknesses in economic data are noticeable, such as: rising unemployment, leveling-off of productivity, and overall output decreases. Money flows start to move from equities to fixed income investments and money markets and accelerate as recession deepens.  Consumer staples and utility companies are a couple of the very few steady performers in this cycle.  Financial stocks are particularly hit hard as defaults, foreclosures proliferate and losses mount, sometime beyond the breaking point.  Real estate investments fall rapidly as lending standards increase significantly and lending money evaporates.  Perceived safety investments such as US government bonds and commodities (i.e. gold and silver) gain in value.  This is the current cycle we have been in since the end of 2007 and these investments have flourished.

Recovery: Economic data, such as output and employment are at their lowest points. Consumer confidence and spending also hit new lows. Productivity falls as industrial output bottoms and morale decreases. Money flows into equities are at their lowest point, while money market investments are in favor.   Financial stocks start to regain favor.  This is the economic cycle we are about to enter.  The stock market anticipates the recovery by six to twelve months and may start rising even when economic data looks its weakest.

Growth: Rising employment and GDP growth, and increasing demand for stocks. Productivity and output expand and the strength of the economy picks up, and consumer confidence increases.  Small company stocks gain strength and consumer discretionary spending and retail stocks pick up.  Industrial companies and information technology sectors do well as companies receive larger orders and feel confident to upgrade factories and computer systems that have been long overdue.  Bonds pick up as the credit quality of companies improve assuming that inflation stays stable during this period.

Inflation: Consumer and equity prices rise rapidly.  Productivity and output remain strong during this cycle, but may start to show signs of weakness and inconsistency. Consumer confidence reaches highest levels.  Energy sectors and large growth companies along with commodities do the best in this environment.  Bonds start to fall in value as interest rates rise to fight inflation.

So what investments can we use in every investment cycle?  As noted above, stocks, bonds, real estate, commodities and cash are individually suited for certain economic cycles.  Exchange traded funds however cross the boundaries of all asset classes for a very low cost and make it much easier to invest with the economic winds at our back.  Below are some additional reasons why ETFs work for almost any portfolio.

Exchange-Traded Funds: The Investment for the 21st Century
•    Can invest very specifically in industries or asset classes
•    Less restrictive than mutual funds thus building diversification even in smaller portfolios
•    The ability to buy and sell shares just like a stock so the investor can move in and out of investments in rising and falling markets immediately
•    Lower fees and related expenses versus mutual funds
•    Liquid markets
•    Immediate information on price, performance, and availability
•    Long and short positions can be established easily to protect in high volatility markets
•    Lower volatility based on performance of a group of stocks or index versus a single security

While exchange trade funds are an excellent choice for many portfolios they are not the answer for everyone.  We still recommend a well diversified portfolio that meets your objectives and is within your risk and volatility tolerances.  Certain ETFs can be very volatile and a portfolio with ETFs still needs to be reviewed by an investments advisor on a regular basis.