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Stock Market Cycles

Interest rates usually rise throughout Stages I and II except possibly briefly between the low in common stock prices and the trough in economic activity in the economic/stock price cycle. Long-term bond prices fall. Money market securities retain their value and receive increasingly higher yields as the economic expansion pressures short-term interest rates higher. However, their stable principal does not participate in the common stock bull market of Stages I and II. Although returning more than long-term bonds, money market securities are not the highest return asset allocation in Stages I and II. Common stocks are the highest return asset allocation in these Stages.

WHEN TO EMPHASIZE MONEY MARKET SECURITIES

A portfolio asset allocation that emphasizes money market securities is most desirable when both common stock and long-term bond prices are falling. This simultaneous decline occurs between the high in common stock prices reached at the end of Stage II in Figure 3.1 and the most severe credit tightening, possibly a squeeze or crunch, of the economic/stock price cycle reached shortly after the peak in economic activity at the end of Stage III or in early Stage IV.

Common stock prices experience the most precipitous part of their fall in late Stage III and early Stage IV. Expected earnings decline sharply. The numerator in the Equation (3) valuation framework falls. At the same time interest rates rise and may spike sharply. Fed-supplied liquidity is curtailed. Demand for money remains high. Long-term bond prices fall. The denominator in the Equation (3) valuation framework rises rapidly. This reflects combination 7, the most bearish for common stock prices, from Table 1.1.

Investors do not want to be in common stocks or in long-term bonds in Stage III or early Stage IV. Both securities are losing value at their most rapid rate in these periods of the economic/stock price cycle. Money market securities offer the only positive return to be garnered over this relatively short span in the cycle. Money market securities do not lose value and still have a positive return. Common stocks and long-term bonds have negative returns.

WHEN TO EMPHASIZE LONG-TERM BONDS

An asset allocation should emphasize long-term U.S. Treasury bonds in most of Stage IV, after any credit crunch at the beginning