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Stock Market Cycles

framework for these sectors fall more slowly than the rate of decrease in interest rates in the denominator. The common stock prices of these sectors rise while the rest of the stock market falls. The expected earnings of other sectors may be countercyclical and remain stable or grow, furthering their relatively superior sector return.

Common stocks most likely to show superior returns relative to the general stock market during Stage IV are labeled “defensive.” Most of these firms have expected earnings that are resistant to the negative effects of the recession. Their earnings environments are noted for the necessity and income inelasticity of their product or service. Prominent examples include residential electrical and gas utilities, food producers and retailers, and pharmaceutical companies. These are necessities that consumers must have regardless of the recession and its negative impact on their incomes. Sector rotation investors envision moderately declining, stable, or moderately rising earnings for these firms. In the first situation the expected earnings in the numerator of the Equation (3) valuation framework are declining at a lower rate of decrease than the rate of decrease in interest rates in the denominator. In the other two situations expected earnings are steady or modestly rising while interest rates in the denominator are falling. These situations reflect combinations 9b, 3, or 2, respectively, of Table 1.1. The common stock prices of these defensive issues rise during Stage IV.

SUMMARY

Active asset allocation should emphasize different proportions of common stocks, money market securities, and long-term U.S. Treasury bonds in different Stages of the economic/stock price cycle.

Stage I asset allocation should emphasize common stocks. Expected earnings are usually rising at their fastest rate over the economic/ stock price cycle and at a much faster rate of increase than interest rates. Common stock prices rise throughout Stage I as a result.

Stage II asset allocation should continue to emphasize common stocks. The rate of increase in expected earnings, albeit slower than in Stage I, remains greater than the rate of increase in interest rates. Common stock prices continue to rise.

Stage III asset allocation should emphasize money market securities. Interest rates rise most rapidly in Stage III. The rate of increase in interest rates overtakes the now slower rate of increase in expected



	68	Stock Market Cycles

	framework for these sectors fall more slowly than the rate of decrease in interest rates in the denominator. The common stock prices of these sectors rise while the rest of the stock market falls. The expected earnings of other sectors may be countercyclical and remain stable or grow, furthering their relatively superior sector return. Common stocks most likely to show superior returns relative to the general stock market during Stage IV are labeled “defensive.” Most of these firms have expected earnings that are resistant to the negative effects of the recession. Their earnings environments are noted for the necessity and income inelasticity of their product or service. Prominent examples include residential electrical and gas utilities, food producers and retailers, and pharmaceutical companies. These are necessities that consumers must have regardless of the recession and its negative impact on their incomes. Sector rotation investors envision moderately declining, stable, or moderately rising earnings for these firms. In the first situation the expected earnings in the numerator of the Equation (3) valuation framework are declining at a lower rate of decrease than the rate of decrease in interest rates in the denominator. In the other two situations expected earnings are steady or modestly rising while interest rates in the denominator are falling. These situations reflect combinations 9b, 3, or 2, respectively, of Table 1.1. The common stock prices of these defensive issues rise during Stage IV.

	SUMMARY Active asset allocation should emphasize different proportions of common stocks, money market securities, and long-term U.S. Treasury bonds in different Stages of the economic/stock price cycle. Stage I asset allocation should emphasize common stocks. Expected earnings are usually rising at their fastest rate over the economic/ stock price cycle and at a much faster rate of increase than interest rates. Common stock prices rise throughout Stage I as a result. Stage II asset allocation should continue to emphasize common stocks. The rate of increase in expected earnings, albeit slower than in Stage I, remains greater than the rate of increase in interest rates. Common stock prices continue to rise. Stage III asset allocation should emphasize money market securities. Interest rates rise most rapidly in Stage III. The rate of increase in interest rates overtakes the now slower rate of increase in expected