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Vol. 36 No. 2 March 23, 2009 The Ups Win by Bill Dickneider D o the stock market and the economy have any thing in common with practicing a sport like basketball? In a way, they do. During some practice sessions, you can be at peak performance; it seems like you can’t do anything wrong. At other times, the ball refuses to go through the hoop; it seems like you can’t do anything right. Despite these ups and downs, however, you continue to practice, and your skills gradually improve. Our economy and the stock market also have their ups and downs. After peaking at 14164 in October of 2007, the Dow Jones Industrial Average (Dow) fell to 6547 by early March of 2009 — a decline of more than 50 percent. The latest report from the Department of Commerce showed that the economy’s total production (inflation-adjusted gross domestic product, or real GDP) fell by an annual rate of 6.2 percent in the fourth quarter (last three months) of 2008. A business cycle is a pattern of repeated fluctuations over time, in which the economy expands, peaks, contracts, and then reaches a trough or bottom from which a new expansion begins. Cycles t’s easy for investors to become discouraged during times like these, just as discouragement can accompany practice sessions that don’t go well. But ups and downs are nothing new to the economy and the stock market. They’ve survived many of these fluctuations — otherwise known as business cycles. I The chart below shows business cycles in our economy from 1950 through 2008. During these years, the economy survived 10 periods when contractions in production, Sources: Economic Data - Federal Reserve Bank of St. Louis, FRED® Data Base, http://research.stlouisfed.org/fred2/; National Bureau of Economic Research, http://wwwdev.nber.org/cycles/cyclesmain.html. employment, and incomes were severe enough to be called recessions.1 change in step with the economy as it moves through the various stages of the business cycle. The current recession began in December of 2007 and has lasted 15 months so far. The average length of the 9 previous recessions was about 10 months, with those of 1973 to 1975 and 1981 to 1982 lasting 16 months. The recession of 1973-75 (Chart 1, #5), began in the fourth quarter of 1973, after the economy peaked and began contracting. The downturn lasted until the economy reached a trough in the first quarter of 1975. At that point, total production (real GDP) had fallen 2.2 percent during the recession. Similarly, the Dow Jones Industrial Average had declined 34.9 percent.2 No two business cycles are exactly alike. Their length, severity, and cause can differ — as well as their effects on employment, production, and stock prices. What’s more, the duration and strength of any given contraction or expansion doesn’t indicate the timing or strength of the next expansion or contraction. The scale shows proportional changes in the Dow, Source: Dow Jones Indexes, http://www.djaverages.com/?view=industrial&page=index-data. Chart 1 on the first page shows that despite the ups and downs of the business cycle, the total production of goods and services still grew by about $10 trillion between 1950 and 2008. Similarly, the stock market also rose over the same period, as Chart 3 above illustrates. Even though the Dow declined due to recessions and other events, it still rose from 206 in 1950 to 8776 by the end of 2008. Over the years, the ups have clearly beaten the downs in the stock market and general economy. 1 The National Bureau of Economic Research defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. Between trough and peak, the economy is in an expansion.” http://www.nber.org/ cycles.html. Sources: http://data.bls.gov/cgi-bin/surveymost?ce; Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/ categories/18; Yahoo!Finance, http://finance.yahoo.com/q/ hp?s=^DJI Chart 2 above illustrates some of the effects of the current recession. Stock prices began falling in 2007, before employment and real GDP turned down in 2008. This behavior of stock prices isn’t surprising, however, because stock prices are “forward looking,” which means they reflect investors’ anticipations of the future. If investors correctly expect a recession in the near future, stock prices may fall even before the downturn begins. In contrast, payroll employment tends to 2. The stock market is generally forward looking, so stock prices are likely to turn up before the economy reaches a trough and the recession ends. Accordingly, the Dow’s changes on the chart show the percentage change from the prior peak to the quarter just before the recession’s end. To Think About ✔ Do you think the stock market’s ups will continue to win in the future? Why or why not? ✔ Use the web site in footnote #1 to compare the duration of the expansions beginning in 1981 and 2001.