3. Literature Review
3.1. Business and Market Cycles
國
立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
3. Literature Review
3.1. Business and Market Cycles
Business cycles: Definition
The answer to our research question will be determined through two different studies that will lead us to a general conclusion. The first study will be conducted with the purpose to identify market cycles around presidential elections for the selected indices of France and Taiwan.
Before going through the past studies and findings in the next part of this literature review, we need to understand the general concept of market cycles. To see how cycles occur on financial markets, we need first to remind a really well-known economic theory that has been discussed for many years: Business cycles. This first step is mandatory as business and market cycles are really closely linked. The purpose of this first part of literature review is then to understand what business cycles are, how to identify them and what the main explanatory theories are.
Once this will be done, it will be possible to find out the nature of the relationship between economic and market cycles to enter the second part of our literature review.
First of all, the economic activity fluctuates over time. These fluctuations, divided in period of expansion (upswing of economy), recession, depression (downswing of economy) and recovery, define business cycles. This is in 1946 that the two economists Burns and Mitchell gave the definition of business cycles, still applicable nowadays, in their book called Measuring Business Cycles:
“Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions
‧
國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle;
in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar characteristics with amplitudes approximating their own.”
The methodology to determine business cycles is, in general, very similar between the institutions responsible of this work but may vary in some specific points. In the United States for example, the National Bureau of Economic Research (NBER) is the institution which determines the Business cycles dates in the country. Their methodology to define a recession period differs from the financial press in the sense that the Bureau does not base it on a “two consecutive quarters of decline in real GDP”. Rather, for the organization, a recession “is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”. Period of expansions are determined, on the other way around, by a significant increase in economic activity. These definitions, from the NBER, help us to have a clear understanding on the process and methodology used to identify business cycles. During the history, many different theories have come out to explain the presence of business cycles in our economy. On one side, John Maynard Keynes and his supporters, the Keynesians, have interpreted the presence of business cycles as a sign of market failure. They encouraged the intervention of the state and the use of economic policies in order to minimize the impact of economic activity fluctuations until the optimum level of employment would be reached. The main alternative point-of-view has been given by the Neoclassical Macroeconomics supporters through the name of Real business cycle theory. Kydland and Prescott were the main
‧
國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
contributors to this theory which explains the business cycles by the presence of technological shocks. These shocks can be seen as a change in the level of productivity. If we think from a
“demand-supply model” point-of-view, it would be interpreted as shifts of the supply curve at different point of time. As a result, each time the supply curve shifts from a side or another, a new equilibrium (intersection point between demand and supply) would be found. The economy would then fluctuate and create cycles according to the equilibrium change between demand and supply. The supporters of this theory do not call for a state intervention in the economy. For them, it could even worsen the situation. In this sense, this theory differs and comes in contradiction to the Keynesianism.
Business and Market cycles: What relationship exists?
As we mentioned, the first step of our analysis will be to determine whether or not we can identify financial market cycles in France and Taiwan. The notion of ‘business cycle’, that we tried to briefly explain above, is the most-known but differs from the market cycle in the sense that it takes into account the GDP to determine the fluctuations of the economic activity of a country while market cycles are the representation of fluctuations on financial markets (index fluctuations for example). Can we find any relationship between business and market cycles?
A general relationship exists between them as the stock market tends to be a leading indicator of the business cycle. This is Sam Stovall who proposed in 1995 his model of ‘sector rotation’
which involved the relationship between business and market cycles. In his analysis, investors and stock market try to anticipate the business cycle in order to maximize their benefits (The earliest you can anticipate an upcoming trend in the economy, whether it is a growth or a downturn, the most important the benefit from an investment). The following graph is extracted
‧
國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
from the book written by Stovall in 1995 called, The S&P guide to Sector Investing and shows well how the stock market cycle (blue color) imitates the business cycle (yellow color) but especially how the first one anticipates the second. Nevertheless, the relationship has been made, only established a relationship between economy and indices (which include a large number of stocks belonging to different industries). This is the reason why the second part of the analysis of Stovall is to identify which sectors are outperforming at different period of time of a business cycle. In, fact, industries behave really differently at certain period of time and the analyst is trying to link the performance of the main sectors with economic cycle phases to give investment recommendations according to this factor. We can see it, also on this graph, by the numbers displayed at different points of the cycle. It shows the investors at what time the stocks of each sector should be bought, considering they are outperforming.
Graph 3: Business Cycle and Relative Stock Performance
‧
國立 政 治 大 學