 Hello and welcome to the session. This is Professor Farhad in which we would look at a topic called the business cycles. This topic is important if you are studying investments because to select securities for your portfolio, you need to understand the business cycles. Before I start, I would like to remind you to connect with me on LinkedIn. If you haven't done so, please subscribe to my YouTube where I have a little bit close to 2000 plus accounting, auditing, finance, as well as Excel tutorials. If you like my lectures, please like them and share them. On my website, farhadlectures.com, you will find additional resources to complement and supplement this course as well as other courses. So what is the business cycle? Well think of the economy like the season during the year. We have four seasons. We have the winter season, spring, summer, fall, then we go back to the winter season. So we go through repeatedly experiencing periods of expansion and contraction. Now it doesn't work exactly like the seasons where it's three months for each, but the point is we go through ups and downs through the economy. The length can be very in the depth. How long and how severe, whether it's the expansion or the contraction can be irregular. It's not the same. So these reoccurring cycles or reoccurring pattern of recession and recovery, this is what we call the business cycles. Now we have a transition points with those business cycles. They are called peaks. Well simply put, this is a peak like at the top and we have trough with something at the bottom. We have peaks and trough. A peak is the transition from the end of an expansion to start of a contraction. So you peak here, you reach the max and you start to go down. Then you go all the way down at the bottom and this is the trough occurs at the bottom of a recession just as the economy enters a recovery. Now if you can, if you can predict, think about it, if you can predict those business cycles, what should you do at the peak? You should be selling. You should sell securities and what should you do at the trough? You should buy. You should buy. Generally speaking, the average investor, I'm talking about the average investor, what happened is at the peak they buy because everybody is doing great and they think it's going to go forever and at the trough they get scared and they sell. So professional or people that know what they're doing, you will do exactly the opposite. Now when we go through the business cycles, not all companies are the same. Certain companies do better than other companies and we have to differentiate between different industries and we're going to talk about the industries in the next section. But simply put, we can break the industries into two types, cyclical and industries. So as the economy goes through different stages of the business cycle, the relative profitability of different industry group might be expected to vary. Not all companies do the same in an expansion and the same in a contraction. They're not all the same. For example, at the bottom, one would expect that cyclical industries, those with above average sensitivity would tend to outperform other industries at the bottom. Once we are starting to recover at the trough, once we are starting to recover, those companies, they will start to do better. They will start to perform better because we hit the bottom. Now we are starting to recover. Examples are producers of durable goods, automobiles, bulldozers, trucks, large household items. Once we hit the bottom and the economy is recovering, these companies, they will start to do well. Why? They, when the economy, remember, we have the peak and we went down. During this period, when we were going down, people deferred those purchases. People and companies. So they deferred those purchases during the recession. And now we reach the bottom when we're starting to go up. Then once we know, once we know, and we're going to talk about the leading indicators, once the economist or the expert or the professional knows that now we're turning around, we're turning to go up, these companies will start to do better because all these people that deferred their purchase, they're doing it now. Other cyclical industries will be producers of capital goods, big, big ticket items. This is what we're talking about here. And goods that are produced, that are used to produce an other product. If you supply the auto industry, if you supply them with tires, then you will start to do well as well. So when they demand a slack, few companies will be expanding and purchasing capital goods. So when we are going down, this is when the demand is slack and we'll stop. When do we start? We start when we're going up again. Therefore, if you can time the market, that's really good. Therefore, the capital good industries beers the brunt of a slowdown, but does well at an expansion. So if we're going down, they don't do well. But as soon as we start to go up, they will start to do well as well. Until we reach the bottom and I'm sorry, enriched, we read another peak, then it will go down. Then they will suffer again. Usually those companies, they will have like Caterpillar, any big item companies, construction companies, they have a beta greater than one high stock, high beta stock. This is high beta stock. So a beta greater than one, because they go up higher than the market and on the way down, they do worse than the market as well. So in contrast to cyclical industries, we have defensive industries. The defensive industries, they are a little bit less sensitive to the business cycle. So they're not affected by the business cycle as much as the cyclical industries. Think about your household. In other words, think about your utility bill. Your utility bill, it's going to be almost the same whether we are going through a recession or whether we are going through an expansion. You might spend a little bit more, less few dollars, more or few dollars less, but it doesn't make that much of a difference. Like for example, utilities companies, they'll basically make the same income regardless whether the economy is going through a recession or an expansion. These are industries that produce goods for which sales and profit are least sensitive to the state of the economy. What are some examples? Think of food producers and not all food producers, for example, staple goods. If you're buying spaghetti or ketchup, it doesn't matter whether we are going through an expansion or a recession. Actually, if we're going through a recession, these companies will even do better. Pharmaceutical firms. Again, you need to buy your prescription, whether we are going through a recession or an expansion. Public utilities. Again, we talked about your phone bill, your electric bill. These industries actually will outperform others because in a recession, the other companies, they suffer. Therefore, the professionals, they sell those cyclicals and they go into defensive companies. Some specific companies will be the dollar store, Walmart. It doesn't matter. Walmart actually does better in a recession. Hines, Ketchup, McDonald's. Think of consumer staples. Companies that do well regardless of the economy. Think of these companies. Beta closer to, these betas would be closer to one, closer to the market. Now, because the economy reaches a peak in a trough, now it's important if you can predict those peaks and troughs. So what do we look at? We look at what's called economic indicator because we go through a business cycle. It's not surprising that we'll try to predict those business cycles. How do we predict those business cycles? The conference board publishes a set of cyclical indicators to help forecast, measure and interpret short-term fluctuation in the economic activities. Basically, we have three types of indicators. We have leading indicators. In my opinion, those are the most important. Are those economic series that tend to rise or fall in advance? Because that's what you want to know. You want to know in advance. It's, sometimes it's too late if we're looking at a lagging indicator. If you could look at those leading indicator and try to predict what's going on, that's the best way to do it. Again, this is not a science, this is an art. Also, we have a coincident and lagging indicator as their name suggests. They move in tandem or after the economy went through the cycle. Let's take a look at some of those indicators just to get an idea. What are we talking about here? Again, I said leading are the most important. One thing is the average weekly hours of production workers. For example, if we're looking at the manufacturing industry, and especially if our economy is manufacturing. So if we can't find out, not if we can't find out, if the average weekly workers is going up, it means companies are working their employees. Maybe they're working them over time. Maybe they're working them longer hours. What does that mean? Why do you work your employees? Because you are producing. Why do you produce? Because you have orders. So if the week, why do you have orders? Eventually you're going to ship them. So that's why it's a good indicator. Initial claims for unemployment insurance. That's very important. It comes out on Thursday a 30 every week. That's important. If more people are being laid off, then this is what's going on lately is because of the coronavirus. This is a leading indicator that if less people are working, you have less consumer power. You have less consumer power they're going to buy, less goods and services, especially from cyclical companies. They would still go to Walmart, but they're not going to buy that new car from GM or Ford. So this is going to tell us something about the economy. Manufacturing new orders. Notice it's orders. It doesn't have to be sales. As long as you have the order, the sale will follow. So the order comes before. So we don't have to wait until we make the sale. Orders are good enough for us to be a good indicator. Institute of supply management index of new order. And I believe this one, if there's a line 50 above 50 or below 50, above 50 is good, below 50 is not good. New orders of non-defense capital goods. Again, look what we're looking at. Only the new orders, the new orders. New private housing unit authorized by local permits. Basically permits are like orders because before you buy a house, I'm sorry, before you construct the house, not buy before you construct the house, you need a permit. And it may take a month or two to start the actual construction. If you see construction companies are getting more permits, this is a good sign for the economy. Because when you buy a house, the new homeowner will have to buy all sorts of items like furniture, TVs, electronics, kitchen supplies, so on and so forth. That's a good, that's a good, these are good leading indicators. These are coincident indicator or coincident indicator. Basically they happen, they tell you what's going on right now. And these are lagging indicators. They come after the fact. Like for example, average duration of unemployment. Now we know after six weeks or eight weeks, the duration is such and such. That's after the fact. Ratio of manufacturing and the trade and the trade inventories, the sales. So basically what we're looking at is how are we doing in terms of inventory and sales as our inventory turning over? If it's not, it's not good. But when do we know this? We have the sales and we have the inventory after the fact. So those are lagging. They happen at the end of the after the cycle happened. They kind of confirm what happens. Now, how good are lagging and leading indicators? Let's take a look at this picture. And basically this area here is a recession. So we know what we're looking at. This is the year and this is the month. So let's take a look at this leading indicator that's in blue. We see that the leading indicator, it peaked right here. I still remember, maybe some of you would remember this. It peaked March 2001. So this is March 2001. It peaked, then it went down, down, down, down. It reached the trough in 2001 in November. Then it started to go up. So notice we went through it. When this is going down, this is the contraction. So notice it's a leading indicator. Then it went up and again, it reached a peak. December 2007, then it started to go down. At some point here, we enter a recession. Then it went all the way down. It went till 2009, June 2009, then it went up. And it went up like this. So notice here that the leading indicator, they do happen before a recession. But can you predict? Look, this is the amount of time before the recession and this is the amount of time before the recession. I mean, are you gonna say it's equal? You might say it's equal, but again, it's very much irregular. The other thing I want you to notice is, notice what happened once we hit bottom. We like, it's a V, they call it a V recovery. So when we hit bottom, it goes up very fast. Why? Because the government, the physical policies and the monetary policies that we talked about in the prior session, they will intervene here and the economy will start again. Now this is called the V recession. There is the V, there is the U where it's taken too long. Now, that's the big discussion when we had the coronavirus. Are we gonna have a V recovery or a U recovery or a W recovery or an L recovery where we'll just go flat or a square root recovery or what they're talking about now before the election. This is the big thing now is K recovery. And this is interesting. It means some people are experiencing more wealth these days than other people. If you want my opinion, we're going through a K recovery. And that's my opinion based on what I see, based on common sense. More people are benefiting from this economy, what's going on now than others. I mean, give you a simple example, Amazon. Amazon is just killing all the other businesses. Amazon, all the other local businesses, medium-sized businesses, that's it. People are buying online, so Amazon will be benefiting here. All the other businesses like commercial property, all these smalls or those commercial properties, they're going down here. For example, I'm in the online business education. Like luckily I'm doing good because more people are going online to learn. Well, that's good for my YouTube. That's good for my business. But if you have a physical school or if you have a traditional education, then you're not benefiting. So yes, I believe in my opinion, we're going through a K recovery and this is gonna change a lot in our economy and our policies down the road. That's what I predict anyhow. But I believe it's a, we're going through as a K recovery. That's my personal opinion. The most important indicator in my opinion is the stock market. Stock market is the most important indicator. The stock market, the stock market price index is a leading indicator. Simply put, what we assume, we always assume that the stock market leads six to 12 months, almost a year, depending on how efficient is the market. I believe at least the stock market tells you what's going on six months ahead. So if the stocks are going up now, it means we're going to be doing good for the next six months economically speaking because the stock market, based on the efficient market hypothesis, they can predict the future six months ahead. That is what would be expect as stock prices are forward-looking predictor for future profitability. And I do believe in that. I'm a strong believer in the stock market. Now, unless there is something unusual, like for example, let's assume the president caught the coronavirus. God forbid, the worst thing happened for the president. Well, then it's different. Or when you got the coronavirus itself, those are not usual time. But in normal time, the stock market is a major leading indicator. So simply put, because the stock market is a major leading indicator, this makes the series of leading indicator much less useful for investment policy. But you want to use them as much as possible. By the time the series predict an upturn, the market has already made it smooth. So the stock market even are before, they react before six or 12 months before what's actually going to happen. I believe in that. And the next session, we would look at the industry analysis. As always, I'm going to remind you, if you like the session, please like it and share it. And check out my website, farhatlectures.com for additional resources for this course, as well as other courses, especially if you are studying for your CPA exam. Good luck and most importantly, stay safe. Thank you.