The economist’s address is highly optimistic. He predicts that the
real gross domestic product of the United States will increase over 4 per-
cent during the next four quarters, a very healthy growth rate. There will
be no recession for at least three years, and even if one occurs after that,
it will be very brief. Corporate profits, one of the major factors driving
stock prices, will increase at double-digit annual rates for at least the
next three years. To boot, he predicts that a Republican will easily win
the White House in next year’s presidential elections, a situation obvi-
ously comforting to the overwhelmingly conservative audience. The
crowd obviously likes what it hears. Their anxiety is quieted, and many
are ready to recommend that their clients increase their stake in stocks.
The time of this address is the summer of 1987, with the stock mar-
ket poised to take one of its sharpest falls in history, including the
record-breaking 23 percent decline on October 19, 1987. In just a few
weeks, most stocks can be bought for about half the price paid at the
time of the address. But the biggest irony of all is that the economist is
dead right in each and every one of his bullish economic predictions.
The lesson is that the markets and the economy are often out of
sync. It is not surprising that many investors dismiss economic forecasts
when planning their market strategy. The substance of Paul Samuelson’s
famous words, cited at the beginning of this chapter, still remains true
more than 40 years after they were first uttered.
But do not dismiss the business cycle too quickly when examining
your portfolio. The stock market still responds quite powerfully to changes
in economic activity. The reaction of the S&P 500 Index to the business cycle
is displayed in Figure 12-1. Although there were many “false alarms”
when a substantial market decline was not followed by a recession, stocks
almost always fell prior to a recession and rallied rigorously at signs of an
impending recovery. If you can predict the business cycle, you can beat the
buy-and-hold strategy that has been advocated throughout this book.
But this is no easy task. To make money by predicting the business
cycle, one must be able to identify peaks and troughs of economic activ-
itybeforethey actually occur, a skill very few if any economists possess.
Yet business cycle forecasting is a popular Wall Street endeavor not be-
cause it is successful—most of the time it is not—but because the poten-
tial gains are so large.
WHO CALLS THE BUSINESS CYCLE?
It is surprising to many that the dating of business cycles is not deter-
mined by any of the myriad government agencies that collect data on
208 PART 3 How the Economic Environment Impacts Stocks