Macroeconomics and Stock Market Timing

January 2019

LEARNING OBJECTIVES OUTLINE

1. What is market timing?
2. Define business cycles.
3. Investigate expansions, recessions, and
depressions
4. Differentiate between cyclical and non-
cyclical industries
5. Research monetary and fiscal policies
6. Explore government surpluses and
deficits
7. Probe stock market’s lead-lag
relationships
8. Review the Conference Board’s leading,
coincident, and lagging economic indicators
9. Study industry analysis
10. Learn what causes market bubbles
1 Dollar Cost Averaging
2 Business Cycles
3 The Subprime Mortgage Crisis
4 Federal Government Economic Policies
5 A Leading Indicator: The Stock Market
6 Populating Tables and Graphs with Data
7 Other Leading Economic Indicators
8 Market Bubbles
9 Focusing On A Single Product
10 Conclusions

A business cycle is a period of time that includes both a peak and a trough (or, alternatively, a
trough and a peak) in a nation’s business activity. A nation’s income (namely, Gross National
Product or Net National Product) is usually used as a measure of its business activity. The
time from a peak to a trough is called a recession. The trough of a recession is also the
beginning of an expansion that lasts until the next peak. During the last century the shortest
complete business cycle lasted 17 months, 1918-1920, and the longest business cycle lasted
128 months, 1991-2001. The individual business cycles accumulate to form a never-ending
sequence of alternating peaks and troughs (or troughs and peaks) that are repeated regularly,
but each individual cycle is unique in terms of its duration, volatility and causes.

Stock market prices have a strong tendency to rise and fall in the months before the peaks and
troughs in business activity, respectively. Since the timing of purchases and sales in the stock
market has a large impact on an investor’s gains and losses, profitable investing requires
attention to the business cycle. Many investors claim good market timing can contribute as
much to a common stock investors’ gains as good stock picking.

Most day-to-day stock price fluctuations are random wiggles that are not worthwhile to
analyze. In contrast, large price changes and sustainable trends are worthy of analysis. This
chapter passes over stock picking and focuses on stock market timing. Market timing
strategies suggested in this chapter will enable profit maximizing investment decisions to be
made when a recession (or expansion) causes the prices of nearly all stocks to trend
downward (or upward) over a period of months or years. The chapter investigates various
aspects of stock market timing; dollar cost averaging, business cycle analysis, speculative
bubbles, and industry factors are discussed. The market prices of stocks and bonds are not

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 1
highly correlated and, as a result, bond investors will not find this chapter’s suggestions
helpful.

“Buy low and sell high” is an old investing adage that is easier said than done. For example,
consider investing during the Depression of the 1930s. Stock prices began plunging in 1929.
Investors panicked, and for good reasons. During the Depression thousands of U.S.
commercial banks went bankrupt and the unemployment rate reached 25 percent. By the
time the stock market prices troughed (bottomed) in 1932, few investors had the cash or
confidence to invest in the low priced stocks that were widely available. More succinctly, few
investors are good market timers.

1 - DOLLAR COST AVERAGING

Dollar cost averaging (DCA) can be accomplished by buying a constant dollar amount of the
same stock at regularly scheduled intervals regardless of how the share’s price fluctuates. This
strategy assures that more shares will be purchased at low prices, and fewer shares will be
acquired at high prices. Dollar-cost averaging reduces the risk of investing at the wrong time.

---------------------------------------- Top of Example 1 ---------------------------------------------

EXAMPLE 1: Dollar Cost Averaging (DCA)

Suppose an investor makes an annual investment of $100 in a particular common stock on the
first trading day of January for five consecutive years. If the stock’s price is $100 per share
throughout the first year, the investor’s $100 annual investment will be enough to purchase
one share during year 1. If the stock’s price declines $20 to $80 during year 2, the investor’s
$100 will buy [$100 divided by $80 equals] 1.25 shares in year 2. Assume the stock’s price
falls another $20 to reach $60 in the third year. This $60 price will allow the DCA investor to
acquire [$100 divided by $60 equals] 1.667 shares in year 3. Assume that in year 4 the price
rises $20 to reach $80 per share, which allows the investor to buy [$100 divided by $80
equals] 1.25 additional shares in year 4. During year 5 the stock’s price rises another $20 to
regain the initial price of $100 per share in year 5. Thus, in year 5 the investor’s $100 will buy
1 share. Summarizing, the DCA investor invested a total of [$100 per year times 5 annual
investments equals] $500. During this five year period the investor accumulated a total of [1
+ 1.25 + 1.667 + 1.25 + 1 =] 6.167 shares of the stock at an average cost of [$500 divided by
6.167 shares equals] $81.08 per share.

If the DCA investor sells the 6.167 shares for $100 per share at the end of year 5 the total
proceeds will be [6.167 shares times $100 per share equals] $616.70. Since the investor spent
$500 to buy a portfolio worth $616.70, the investor earned [$616.70 proceeds divided by
$500 total investment equals 1.2334 = 1 + .2334 or] a 23.34% gain from five years of DCA
investing.

--------------------------------------- Bottom of example ---------------------------------------------------

Since the number of shares that can be purchased in Example 1 varies inversely with the per
share purchase price, dollar cost averaging allows more shares to be purchased at low prices
Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 2
and fewer shares at high prices. Making uniform investments at equally spaced intervals
throughout the business cycle reduces the risk of incurring a loss from investing the entire
amount just prior to a market collapse. Dollar cost averaging is rarely the most profitable way
to invest, but it is a simple scheme that can reduce the downside risk. Understanding the
business cycle will enable profitable market timing decisions that permit the investor to
outperform DCA.

2 - THE BUSINESS CYCLE

The market prices of most U.S. stocks collapse during every recession. And, the market prices
of most stocks soar when the nation’s economy is booming. In other words, stock prices vary
predictably with the nation’s business cycle.

The impact of the business cycle on stock prices is not easy to predict because market
bubbles, various industry factors, and alternating good news and bad news that arrives
continuously, complicates business cycle analysis. Each economic fluctuation alters
corporations’ earnings and cash dividend payments, and, also, market interest rates – - these
are the three main factors that determine the value of a common stock.

Every business cycle has two major components - - the expansion and a recession. Economic
expansions are often called booms or recoveries. Expansions occur when most businesses
flourish simultaneously. Expansions last one to ten years, until business activity reaches a
peak. After the nation’s economy reaches an economic peak, slowdowns mark the beginning
of a recession. Recessions are economic contractions that usually last six months to three
years. A recession ends when an economic trough is reached. After economic activity troughs,
if the nation’s economy is healthy, the economy will revive, and the next expansion (boom,
recovery) will begin. This succession of changes in the business environment recurs in a
repetitive and recognizable sequence. However, the phases of a business cycle do not follow a
simple pattern that is easy to predict, as Figure1A illustrates. Table 1 contains statistics about
past cycles in U.S. business activity. Figure1B illustrates how the business cycle and the stock
price cycle interact together through time.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 3
Figure 1A – Hypothetical Peaks and Troughs in the Business Activity
Every business cycle contains one global peak and one global trough in business activity.
The National Bureau of Economic Research (NBER) pinpoints the months in which each past
peak and each past trough occur. Similarly, every stock price cycle contains one global top
and one global bottom. The stock market reaches a global top at the end of a bull market, as
illustrated in Figure1B. A bull market is an uptrend that occurs when the stock market’s price
indexes rise 20% or more. An NBER peak in the business cycle can never come before a global
top in the stock prices because stock price turning points lead the turning points in the
business cycle by a few months. It is essential to distinguish between the many small local

tops and many small local bottoms that each make modest contributions to the formation of
the single global top and the single global bottom that exist within each stock price cycle.

FIGURE 1B - Business Cycles and Stock Price Cycles

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 4
 TABLE 1 - Statistics Measuring the Length of Recessions, Expansions, and Complete
Business Cycles in the U.S., 1919-2011
Metric Months of Months of Months in complete
contraction expansion business cycle

Shortest 6 months (a “mini- 12 months 17 months

phase recession” in 1980) (1981-82) (1918-1920)
Longest 43 months 120 months 128 months
phase (Depression 1929- (1991-2001) (1991-2001)
33)
Average 15 months 47 months 61 months
phase
Synonyms Depression or Economic boom, Peak to peak cycle, or,
recession recovery Trough to trough cycle
Source: National Bureau of Economic Research (NBER) official peak and trough dates.

This discussion focuses on the U.S. because the U.S. has one of the largest economies in the
world; this large size causes the U.S. business cycle to influence other nations’ economies. As a
Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 5
result, the U.S. economy tends to lead, rather than lag, the levels of business activity in foreign
economies.

Figure 2A illustrates fluctuations in gross domestic product (GDP) of the U.S. from 1972 to
2015. GDP is a measure of business activity. GDP refers to the market value of all finished
goods and services produced within a country during an accounting period. Gross national
product (GNP), the index of industrial production (IIP), or other coincident economic
indicators that are highly positively correlated with the GDP are all acceptable measures of
business activity that can also be used on the vertical axis when constructing a graph like
Figures 1A and 2A.

Economists created the National Bureau of Economic Research (NBER) to analyze

historical business cycles. The peak in a business cycle occurs when a recession begins, and
the trough marks the end of the recession and the beginning of the next expansion. The NBER
never makes any forecasts. One or two years after the U.S. economy completes an expansion
(boom, recovery) or contraction (recession), the NBER publicly announces the month in
which the peak or trough occurred. Every NBER peak month marks the beginning of a
recession, and every NBER trough month marks the beginning of a recovery. These official
NBER dates are represented by the six grey vertical strips in Figures 2A and 2B. All
economists utilize the NBER peak and trough dates in their research so studies by different
researchers can be meaningfully compared and, if appropriate, combined. These comparisons
and combinations could not be accomplished if different economists used different peak and
trough dates in their business cycle research.

Some people are surprised by the smoothness of the time-series GDP curve in Figure 2A. Only
the December 2007-June 2009 recession in Figure 2A caused a discontinuity of sufficient
magnitude to be clearly discernible when the grey vertical recession strips are omitted.
Figure 2B was computed from the same data used in Figure 2A to illustrate the annual
percentage changes in GDP. In other words, Figure 2B is a graph of GDP annual growth rates.
Figure 2B shows that the December 2007-June 2009 recession is the only one of the six
recessions shown in Figure 2 that was severe enough to experience months with negative
annual GDP growth rates. The December 2007-June 2009 recession was the deepest and
longest recession the U.S. experienced since the 1930s depression.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 6
FIGURE 2 – Gross Domestic Product, 1972-2017

FIGURE 2A – Gross Domestic Product in U.S. Dollars*

FIGURE 2B – Annual Growth Rates in GDP, in percentage changes*

* The six vertical strips in each Figure delineate six recessions that occur between NBER peak
and trough dates. GDP data from the Federal Reserve Database is graphed.
Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 7
 2A - THE DEPRESSION

The depression was a period during the 1930s when the industrialized nations of the world
suffered extraordinary economic setbacks. The U.S. Depression of August 1929 to March 1933
lasted 43 months, and bad after-effects continued until World War II began in 1941. The U.S.
unemployment rate reached a high point of 25 percent in 1932. Essentially, twenty to twenty-
five percent of U.S. households had little or no income for several years. The Dow-Jones
Industrial Stock Price Average fell 89 percent from September 1929 to July 1932; and, many
investors were bankrupted by the collapse. Thousands of banks also went bankrupt and, as a
result, millions of families lost their life savings. The Federal Deposit Insurance Corporation
(FDIC) was established in 1933 which, unfortunately, was after the depression. The U.S.
depression of the 1930s is a historic milestone that economists around the world seek to
avoid.

2B – THE FACTORS OF PRODUCTION ARE CYCLICAL

To gain more insights into the business cycle let us investigate the factors of production that
produce a nation’s income. These factors are the two major categories of raw material inputs -
- labor and capital. The word labor is self-explanatory. The word capital refers to investments
in plant and equipment. Statistics about the nation’s unemployment rate and its capacity
utilization rate measure the extent to which labor and capital, respectively, are being
employed in a nation.

UNEMPLOYMENT RATE. The unemployment rate measures the percentage of the U.S. work
force that is out of work at any given time. Figure 3 shows that between 1972 and 2015 the
unemployment rate varied from a low of almost four percent to a high over ten percent. The
unemployment rate accelerates rapidly during recessions. During the most recent December
2007-June 2009 recession unemployment started from a lower than usual level and reached a
higher than usual end-of-recession level. After the 2007-2009 recession troughed the
unemployment rate failed to decline as rapidly as it does in most recoveries.

Considerable pain and suffering lies beneath the unemployment statistics. Most of the time
most people enjoy steady employment that enables them to maintain their normal standard of
living. But, at the same time, unemployed people suffer financial hardships, undergo higher
than normal divorce and suicide rates, and experience a steady stream of disappointments.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 8
FIGURE 3 – U.S. Unemployment Rate, 1972-2017, in percentages

Sources: Federal Reserve data. NBER peak and trough dates delineate six recessions.

CAPACITY UTILIZATION RATE. A nation’s capacity utilization rate measures the extent to
which the nation is using its installed productive capacity. It gauges the percentage of slack
capacity that exists in the economy’s plant and equipment. Stated differently, if a nation is
running at a capacity utilization rate of eighty percent, that nation is capable of increasing its
output of goods and services without buying any new plants or equipment. Figure 4 displays
the Capacity Utilization Rate in the U.S. during the past four decades. The U.S. Capacity
Utilization Rate never rises above ninety percent because of raw material outages, labor
strikes and other production bottle-necks keep production from ever reaching full capacity.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 9
FIGURE 4 - Capacity Utilization Rate in the U.S., 1972-2016

Sources: Federal Reserve Database. NBER peak and trough dates delineate the recessions.

The capacity utilization rate and the unemployment rate fluctuate inversely. Stated
differently, the capacity utilization rates in Figure 4 plunge during recessions when the
unemployment rates in Figure 3 are soaring. Contrasting Figures 3 and 4 reveals that the
capacity utilization rate is more coincidental with recessions than the unemployment rate.
Unemployment rates sometimes start climbing months before the economic expansion peaks
(namely, 1979, 1989, 2000, and 2007) as cost-cutting managers foresee the forthcoming
recession and begin laying off workers before the peak in business activity arrives. Figure 3
also shows that the unemployment rates sometimes continue to rise for many months after
the recession ends (late 1991 and 2003, for instance) as layoffs continue after the recession’s
trough is past.

2C – PRICES AND INTEREST RATES

Prices and interest rates tend to rise and fall with the business cycle.

THE INFLATION RATE. The U.S. Government’s Bureau of Labor Statistics computes a new
value for the consumer price index (CPI) every month. The CPI is based on the market prices
of a representative market basket of 300 goods and services that include foods, clothing,
housing, medical care, recreation, transportation, and other items urban consumers typically
purchase. The 300 components have weights that are adjusted every year based on surveys of
consumers’ spending patterns. The percentage change in the CPI is the inflation rate for the
U.S.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 10
 (𝑪𝑷𝑰 𝒊𝒏 𝒎𝒐𝒏𝒕𝒉 𝒕+𝟏)−(𝑪𝑷𝑰 𝒊𝒏 𝒎𝒐𝒏𝒕𝒉 𝒕)
𝐑𝐚𝐭𝐞 𝐨𝐟 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 = (1)
(𝑪𝑷𝑰 𝒊𝒏 𝒎𝒐𝒏𝒕𝒉 𝒕)

EXAMPLE: Computing the Rate of Inflation

If the CPI’s cost for a representative market basket of goods and services equals the index
value of 200 in one month and 202 in the next month, the rate of inflation would be one percent
that month.
202−200
𝐼𝑁𝐹 = = 0.01 = 1% per month (1A)
200

If the CPI increases one percent per month, this can be annualized to obtain the annual rate of
inflation of 12.68%.

𝐴𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑
[1 + ( )] = [1 + (1% 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ)]12 𝑚𝑜𝑛𝑡ℎ𝑠 = (1.01)12 = 1.1268
𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
= 1 + 0.1268 = 1 + 12.68% = 1 + the annualized rate of inflation Thus, the annualized rate of
inflation is 12.68 percent for the month shown in Eqn.(1A).

Two positively correlated lines are charted in Figure 5. The solid line in Figure 5 shows that
inflation tends to rise during economic booms and fall during recessions. Note that during the
December 2007-June 2009 recession inflation reached negative values during the third
quarter of 2009, this means the U.S. experienced a few months of deflation.

FIGURE 5 – Inflation Rates and Six Month U.S. T-Bill Yields, in Percentages, 1972-2017

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 11
Sources for Figure 5: Federal Reserve Database. The shaded areas lying between NBER peak
and trough dates are recessions.

MONEY MARKET INTEREST RATES. High quality, highly liquid debt securities with original
issue maturities of less than one year are called money market securities. Examples of these
debt instruments include bankers’ acceptances, short-term certificates of deposit (CDs),
commercial paper, and U.S. Treasury bills. In Figure 5 a dashed line represents the time path
of market yields from U.S. Treasury bills that have six months till maturity, and the inflation
rate is represented by the solid line. If the market interest rates from all money market
securities were graphed together in Figure 5, it would be apparent that they were all highly
positively correlated with each other and with the rate of inflation. Figure 5 documents the
fact that the level of market interest rates is determined by the level of the inflation rate. The
tendency for market interest rates to rise and fall with the inflation rate is called the Fisher
effect, named after the economist, Irving Fisher, who wrote about this economic relationship
in 1930.1

2D – PERSONAL CONSUMPTION EXPENDITURES

The U.S. aggregate annual consumption expenditures for goods and services are a multi-
trillion dollar amount that is the largest component of the national income. These outlays
continued to grow smoothly through the first five recessions in Figure 6. Only during the
severe December 2007-June 2009 recession did consumers reduce their level of consumption,
by -2.5 percent. Production of this huge annual amount of food, clothing, shoes, health care,
education, recreation, transportation, furniture, and other non-durable goods and services
creates and maintains employment for millions of people in the U.S. Figure 6 shows that
almost all these jobs continue to exist through booms and, happily, even though most
recessions. Stated differently, consumption spending fluctuates moderately and it usually
fluctuates non-cyclically.

Eqn.(2) below sums up the four major components of the annual income of U.S. A nation’s
income is also called its gross domestic product (GDP). In 2010, for instance, consumption
expenditures comprised 70.6 percent of the nation’s annual income, or GDP.

𝐺𝑟𝑜𝑠𝑠 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑁𝑒𝑡
𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑔𝑜𝑜𝑑𝑠 𝑎𝑟𝑒 𝑔𝑜𝑜𝑑𝑠 𝑎𝑟𝑒 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡
( )=( )+( )+( ) + (𝑒𝑥𝑝𝑜𝑟𝑡𝑠) (2)
𝑃𝑟𝑜𝑑𝑢𝑐𝑡, 𝑛𝑜𝑡 𝑑𝑢𝑟𝑎𝑏𝑙𝑒. 𝑑𝑢𝑟𝑎𝑏𝑙𝑒. 20.5%
−3.5%
𝐺𝐷𝑃, 100% 70.6% 12.5%

1
Irving Fisher, The Theory of Interest, Macmillan, New York, 1930.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 12
FIGURE 6 – Personal Consumption Expenditures, 1972-2016

Sources: Federal Reserve Database. NBER peak and trough dates.

Homes, autos, furniture, appliances, toys, jewelry, and other hard goods that last more than
three years are called durable goods. The sales of durable goods behave differently from the
sales of consumption goods. Consumers do not purchase durable goods every year. For
example, a car that is several years old can have its engine tuned-up and get a set of new tires
and, thereby, purchasing a new car can be postponed for a few years. As a result of postponed
purchases, sales of durable goods can decrease by 20, 30, 40, 50, 60 percent or more during
recessions. As a result, sales of durable goods fluctuate cyclically.

3 – THE SUBPRIME MORTGAGE CRISIS

The jagged red line in Figure 7 shows that the subprime mortgage crisis began when the
new home construction started collapsing in May 2006. Two months later the Case-Shiller
home price index (the smoother blue line) started turning downward. A large residential real
estate crisis developed and caused a dramatic rise in mortgage delinquencies, mortgage
foreclosures, bankruptcies, and touched off the December 2007-June 2009 recession in the
U.S. Adverse financial circumstances propelled industrialized nations around the world into a
recession that was caused by the subprime mortgage crisis in the U.S.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 13
The jagged line in Figure 7 shows that new housing starts peaked at slightly over 2.2 million
homes in 2006, and then fell to 500,000 per year in 2008. This breath-taking collapse in the
housing sector threw millions of real estate agents, carpenters, electricians, plumbers,
furniture manufacturers, carpet manufacturers, and other housing-related workers out of
work, and most remained unemployed for years. Government officials did nothing productive
to aid the ailing housing sector.2 The Obama administration established a tax credit of up to
$8,000 for first-time home buyers in 2008-9. This tax credit stimulated new home
construction and supported home prices temporarily. Unfortunately, increasing new home
construction worsened the subprime mortgage crisis. Before, during, and after the $8,000 tax
credit, the U.S. had over one million more homes than it needed, the number of home
vacancies was exploding upward, and home foreclosures were reaching record levels. The
$8,000 tax credit increased rather than reduced these problems.

FIGURE 7 – Case-Shiller Housing Price Index (smooth) & New Housing Starts (jagged)

Source: Federal Reserve Database.

SUMMARY: Three sets of NBER peak through trough dates are shaded in Figure 7. During the
December 2007-June 2009 recession the U.S. unemployment rate exploded upward, as the
Figure shows. Unemployment became a national problem that reduced the federal tax
collections at a time when more government tax revenue was badly needed. Government
officials were slow to recognize the ballooning unemployment problem, and were even slower
in coming to grips with the Subprime Mortgage Crisis of 2007 to 2009.

The seeds for the Subprime Mortgage Crisis were sown in 1938, when Congress created a
government sponsored enterprise (GSE) named the Federal National Mortgage Association
(FNMA, or Fannie Mae). The Federal Home Loan Mortgage Corporation (also called FHLMC,
2
Congress passed the Dodd-Frank Act of 2010 to help prevent future financial crises.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 14
or Freddie Mac) was created in 1970. Government National Mortgage Association (GNMA, or
Ginnie Mae), was created when it was split off from Fannie Mae in 1968. GNMA is a
department within the federal government’s Department of Housing and Urban Development
(HUD). Fannie Mae and Freddie Mac were placed in “conservatorship” in 2008 and the U.S.
Treasury assumed their debts of over one trillion dollars apiece. “Conservatorship” is a word
that, in this situation, means bankrupt. All losses suffered by these three government housing
agencies had previously been paid by the U.S. taxpayers, but the federal government did not
start admitting these payments publicly until Fannie and Freddie were officially declared
bankrupt in 2008. The mortgage financing activities and the multi-billion dollar losses these
federal housing agencies incurred continued for several years as they purchased mortgages
that defaulted. In particular, the agencies reported that 20 to 24 percent of the mortgages they
purchased during the sub-prime mortgage crisis became toxic mortgages. As these home
welfare programs ran out of control U.S. politicians rarely mentioned the Sub-Prime Mortgage
Crisis and did very little to reduce these costly activities.3

TABLE 2 - Who Is To Blame for the Sub-Prime Mortgage Crisis?

Culprits Why?
U.S. Congress and the U.S. Passed National Housing Act of 1934 creating the
President FHA. Created FNMA in 1938 and GNMA in 1968.
Enacted the Home Mortgage Disclosure Act of 1975
and Community Reinvestment Act of 1977 that
pressured banks to make subprime mortgage loans to
applicants with no income, job, or assets (called
NINJAs on Wall Street).
Standard and Poors, Moodys, and Overly optimistic quality ratings. For example, several
Fitch mortgage pools received very high quality ratings of
AAA before they defaulted one year later.
Private mortgage insurers (PMIs), Irresponsibly insured mortgage securities they could
eg, AIG, MBIA, MGIC, FGIC, AMBAC not cover, and then defaulted in 2008.
Government Sponsored Bought and insured default-prone subprime
Enterprises (GSEs): Fannie Mae mortgages (as required by the Home Mortgage
FNMA) and Freddie Mac (FHLMC). Disclosure Act of 1975 & Community Reinvestment
Also: Ginnie Mae (GNMA) from US Act of 1977). Over 22% of these mortgages defaulted
government’s HUD. 2006-2011.
Securities & Exchange Commission Inadequate policing of nationally recognized
(SEC) statistical rating organizations (NRSROs, eg, S&P) and

3
Massachusetts Democratic Representative Barney Franks, who had been a major supporter of
Fannie Mae, Ginnie Mae, and Freddie Mac for many years, changed his thinking and announced
that Fannie Mae, Ginnie Mae, and Freddie Mac should be abolished, but proposed no solution.
Nick Timiraos and James R. Haggerty, “No Exit in Sight for U.S., As Fannie, Freddie Flail,” Wall
Street Journal, February 9, 2010, a front page story. Shortly thereafter, Mr. Frank resumed speaking
in support of Fannie, Ginnie, and Freddie.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 15

Federal Reserve System
Commercial Banks, for instance,
Citibank
Home buyers, namely, millions of
unsuspecting Americans
Real estate brokers
Mortgage brokers
Investment bankers, eg, Merrill
Lynch
Credit Default Swap (CDS) dealers
their overly optimistic ratings of pools of subprime
mortgages.
Inadequate policing of the mortgage origination and
lending process, for example, permitted exaggerated
incomes and exaggerated home value assessments.
Made subprime mortgage loans (as required by the
Home Mortgage Disclosure Act of 1975 & Community
Reinvestment Act of 1977) and quickly sold them to
mortgage pools. Created mortgage pools with
inadequate paperwork and unclear titles to the
underlying homes.
Irresponsibly bought homes with subprime
mortgages, for example, mortgages with down
payments below 20%, exaggerated home values, and
other default-prone facets.
Promoted subprime lending to maximize their income
from the 5% to 6% sales commission they received
from each home they sell.
Maximized their origination fees and sales
commissions by arranging home mortgages for
applicants with no income, job, or assets (NINJAs) and
near-NINJAs.
Hastily created and sold complex and opaque
structures (like mortgage pools, CMOs, CDOs, CLOs, &
CBOs that lacked full disclosure) issued failure-prone
mortgage-backed securities (MBS) to finance the
structures. As a result Merrill was bankrupt when
Bank of America bought it cheap and rescued it in
2008, for instance.
Created CDSs in a huge ($55 trillion in 2008) over-
the-counter market that had no clearing house to
guarantee these CDSs against counter-party risk.

The Sub-Prime Mortgage Crisis was an imbalance between the demand for and the supply of
U.S. homes. Massive mortgage welfare programs Fannie Mae, Freddie Mac, and Ginnie Mae
operated for decades and resulted in an over-supply of homes, many of which were financed
with subprime mortgages. The U.S. home price bubble burst in May 2006. Two months later,
home prices started plummeting too, as shown by the Case-Shiller home price index in Figure
7. Hundreds of thousands of home owners lost their homes and the U.S. was flooded with
empty homes that were sold at continuously lower prices between 2006 and 2012. As millions
of U.S. homeowners watched the values of their homes collapse, they responded by cutting
their spending and increasing their savings. This reduced consumer spending caused the
December 2007-June 2009 recession, which spread worldwide.

In contrast to the badly wounded housing sector, Figure 6 shows that personal consumption
expenditures declined only 2.5 percent during the December 2007-June 2009 recession. This

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 16
reduction in consumption spending is modest; and, what is more remarkable, U.S.
consumption expenditures did not shrink during the preceding five recessions. These steady
consumption expenditures have a huge stabilizing effect on the U.S. economy. For this reason,
some economists call consumer spending the “backbone of the U.S. economy.”

4 - FEDERAL ECONOMIC POLICIES

The President of the U.S. can make government spending proposals. Congress discusses
spending proposals and may enact laws, which are subject to the President’s veto power. As
shown in Figure 8, Congress and the President usually spend more than the U.S. Treasury is
able to collect in taxes and other fees. As a result, the U.S. government is a deficit spender
more frequently than it operates at a surplus.

FIGURE 8 – Total Federal Deficits and Surpluses

As mentioned above, the Sub-Prime Mortgage Crisis and the resulting December 2007-June
2009 recession caused a substantial increase in unemployment. This unemployment reduced
the tax revenues flowing into the U.S. Treasury at a time when the President Obama and
Congress legislated a $787 billion Stimulus Bill. The Stimulus Bill temporarily supported the
U.S. economy and kept the recession from being worse. But, as a result of the Stimulus Bill
and similar federal spending, a series of huge annual federal deficits began in 2008, as shown
in Figure 8.4

4
In October 2008 President George W. Bush created the $700 billion Troubled Asset Relief
Program (TARP) to purchase securities from financial institutions and to strengthen the financial
sector of the U.S. The majority of these investments were repaid with interest by 2010, and most of
the rest were paid off by 2012. TARP supported the weak economy during 2008-2010, and after the
repayments, it cost taxpayers almost nothing.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 17
 4A – THE U.S. TREASURY DEPARTMENT

The U.S. Treasury conducts fiscal operations for the U.S. government. Fiscal operations
include collecting federal taxes to create revenue for the federal government, expending
money (writing checks) for spending projects legislated by Congress, and borrowing money
(selling Treasury bonds) to raise additional cash when the government’s tax revenues are
insufficient to pay for the spending legislated by Congress.

A branch of the U.S. Treasury called the Internal Revenue Service (IRS) collects the taxes
Congress legislates - - this is the federal government’s main source of revenue. The U.S.
Treasury uses its tax revenue to write checks for the things Congress purchases, various
welfare programs enacted by Congress, wars, and other government outlays. On those rare
occasions when a budget surplus occurs, the Treasury can use the excess of tax revenues
over the government’s total expenditures to buy back some of the U.S. Treasury bonds it
issued in previous years. T-bonds sold in previous years were issued to raise cash in years
when the government did deficit spending. Since deficit spending is normal for the U.S.
government, as Figure 8 illustrates, the U.S. Treasury conducts monthly auctions to sell U.S.
Treasury bonds to investors around the world, and the U.S. national debt continues to grow
larger nearly every year.

4B – THE FEDERAL RESERVE SYSTEM

Every civilized nation has a central bank. The Federal Reserve Act of 1913 named the Federal
Reserve to be the central bank of the U.S. and established it as the nation’s monetary
authority. A government’s monetary authority controls the money supply; manages the
nation’s banking system; employs bank inspectors that conduct bank audits; clears millions of
checks daily; manages the country’s credit system; and, manages market interest rates,
inflation, and the balance of payments between nations. Hundreds of back room clerks
working in the twelve Federal Reserve Banks located around the U.S. handle the nation’s
massive check clearing operations. A small army of Bank Examiners police the thousands of
banks that are members of the Federal Reserve System. And, the Federal Reserve’s monetary
economic policies are managed day-to-day by the Federal Reserve’s Open Market
Committee, which meets eight times each year to create policies (or numerical targets for)
governing market interest rates, inflation, and the U.S. balance of payments.

When the U.S. government’s deficits are so large it is difficult for the U.S. Treasury to find
investors to buy more T-bonds, the Federal Reserve, called the Fed, serves as “the lender of
last resort.” The Fed uses its unlimited power to print money to buy the T-bonds from the U.S.
Treasury; this provides the Treasury the cash it needs to pay the federal government’s bills. As
a result of years of deficit spending, the Fed owns more U.S. Treasury bonds than any other
investor. Unfortunately, creating too much new money can be inflationary.

U.S. Treasury bonds owned by the Fed and much of the nation’s gold supply may be seen in
subterranean vaults at daily public tours of the Federal Reserve Bank in New York City.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 18
5 - THE STOCK MARKET: A LEADING INDICATOR
Many investors keep an eye on the turning points (namely, the global market tops and the
global market bottoms) in U.S. stock market prices to help them forecast changes in the level
of the nation’s business activity. Anticipatory stock market trading by these investors is what
causes stock market price indexes to be a good leading indicator of business activity.
Geoffrey H. Moore reported that the S&P 500 Index had a lead time of six to eleven months as
it began collapsing before four U.S. recessions he studied.5 Thus, stock price indexes like the
Standard and Poors 500 Stocks Index and the Dow-Jones Industrial Average are leading
indicators of the nation’s economic activity.6

A Nobel Prize winning economist, the late Paul Samuelson, made a famous remark when he
said: “Wall Street stock price indexes predicted nine out of the last five recessions.”
Samuelson’s humorous remark highlights the ironic fact that a recession does not follow every
stock market collapse. Figure 9 illustrates what Samuelson meant when, for example, in
October 1987 the S&P 500 Index dropped 23 percent and no recession followed. Even when
the stock market plunges several months before GDP peaks, like a well-behaved leading
indicator should do, Figure 9 shows that the lead times (advance warnings) vary widely. In
other words, the stock market is a good leading economic indicator, but the lead time between
the U.S. stock market and the nation’s business activity is not precisely the same in every
business cycle.

5
See Geoffrey H. Moore, Business Cycles, Inflation, and Forecasting, published for the National
Bureau of Economic Research by Ballinger Publishing Company, Cambridge, Massachusetts, 1980,
Figure 9-1, page 192. Looking at this lead-lag relationship from a different angle, Moore’s findings
suggest that iinvestors that are able to forecast the national economy twelve months ahead can use
their economic forecasts to forecast turns in the stock market.
6
Robert J. Barro and Jose F. Ursua, “Stock-Market Crashes and Depressions,” National Bureau of
Economic Research, Working Paper No. 14760, February 2009. Geoffrey H. Moore, Business
Cycles, Inflation, and Forecasting, published for the National Bureau of Economic Research by
Ballinger Publishing Company, Cambridge, Massachusetts, 1980.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 19
FIGURE 9 – Standard and Poor’s 500 Stocks Price Index, 1970-2015

Sources: Macrotrends.com | NBER peak and trough dates.

5A – GETTING CLAWED BY BEARS

Table 3 contains market statistics showing how securities prices behaved during nine
recessions. The first column of Table 3 lists the official start (peak) and end (trough) dates for
each of the recessions. Column two delineates the top and bottom dates for the Center for
Research on Stock Prices (CRSP) Stock Price Index associated with each recession. Note that
the CRSP Index correctly forewarned of each of the forthcoming recessions in Table 3, with
lead times ranging from two to thirteen months before the recession began. The third column
lists the percentage drop in the CRSP Stock Price Index that occurred between the stock
market’s stock price top and bottom dates listed in column two. The percentage plunges in
column three show how much wealth was lost by the stock market investors who did not
foresee the market plunge and liquidate their holdings in anticipation of the forthcoming bear
market. Column four of Table 3 shows that those who invested in long-term U.S. Treasury
Bonds would have enjoyed gains during most of the bear markets. The data in Table 3 shows
that recessions punish stock market investors badly, while T-bond investors usually fare
much better.

TABLE 3 - HPRs from Stocks and Bonds during Nine Recessions, 1951 – 2009
NBER Recessions CRSP Returns Stock Market HPRs HPRs From
Peak & Trough Top & Bottom Top to Bottom U.S. T-Bonds

Jul 53-May 54 Dec 52-Aug 53 -7.15% 1.2%

Aug 57-Apr 58 Jul 56-Dec 57 -13.51% 4.9%
Apr 60-Feb 61 Jul 59-Oct 60 -7.70% 9.4%
Dec 69-Nov 70 Dec 68-Jun 70 -33.03% -4.6%
Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 20
Nov 73-Mar 75 Dec 73-Sep 74 -46.18% -2.9%
Jul 81-Nov 82 Nov 80-Jul 82 -17.80% 5.1%
Jul 90-Mar 91 Dec 89-Oct 90 -14.40% 3.8%
Mar 01-Nov 01 Mar 00-Sep 03 -33.04% 19.2%
Dec 07-Jun 09 Oct 07-Feb 09 -51.57% 21.1% (Approx.)
NOTES: Stock market tops and bottoms in column two are determined from Center for
Research in Security Prices (CRSP) cumulated monthly total returns. Column three is
computed from CRSP cumulative monthly total returns during the stock market drops defined
in column two. The U.S. Treasury bond HPRs in column four are from Morningstar-Ibbotson
in Chicago. Ibbotson’s annual book entitled Stocks, Bonds, Bills, and Inflation contains a
twenty-year T-bond index of cumulative total returns (Table B-5).
__________________________________________________________________________

5B - RIDING BULLS

Table 4 reviews market statistics from bull markets that started with the ending dates of nine
recessions. Column one of Table 4 lists the official starting (peak) and ending (trough) dates
for the same nine recessions reviewed in Table 3. Column two of Table 4 shows the month
when the CRSP stock market index reached its lowest price as each of the recessions drew to a
close. The third and fourth columns show the percentage gains in the CRSP stock price index
during both the first twelve months and the first eighteen months after stock prices troughed
(bottomed). Note that as the nine recessions shown in Table 4 ended, the stock market roared
back in eight of the nine recoveries.

TABLE 4 – Stock Market Recoveries after Nine Recessions, 1951 – 2010

____________________________________________________________________________
NBER Recessions CRSP HPRs during first HPRs during
first Peak & Trough Market Bottoms 12 months 18 months

Jul 53-May 54 Aug 53 34.1% 68.6%

Aug 57-Apr 58 Dec 57 44.8% 57.2%
Apr 60-Feb 61 Oct 60 33.4% 27.8%
Dec 69-Nov 70 Jun 70 44.3% 50.2%
Nov 73-Mar 75 Sep 74 38.7% 74.0%
Jul 81-Nov 82 Jul 82 65.0% 64.4%
Jul 90-Mar 91 Oct 90 37.6% 46.8%
Mar 01-Nov 01 Sep 01 -17.3% -13.2%
Dec 07-Jun 09 Feb 09 58.2% 53.7%
NOTES: Market Bottom determined from Center for Research in Security Prices (CRSP)
cumulative monthly total (capital gain plus cash dividend) returns. Gains during first 12 and
18 months computed from CRSP (value weighted) cumulative monthly total returns.
__________________________________________________________________________

Tables 3 and 4 furnish compelling evidence that studying the business cycle is a worthwhile
activity. The next section discusses other leading economic indicators that can help investors
forecast economic peaks and troughs with enough advance notice to anticipate stock market
turns.
Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 21
6 – LEADING ECONOMIC INDICATORS

Since expert market timers are scarce, the following subsections suggest leading economic
indicators that investors can use to help make profitable stock market timing decisions. These
leading indicators sometimes have lead times over business activity that exceed the stock
market’s lead times.

6A - THE CONFERENCE BOARD’S LEADING ECONOMIC INDICATORS

The Conference Board is a tax-exempt, independent research association founded in 1916.

The Conference Board seeks to provide business and government organizations with
economic and business knowledge they need to improve their performance and to better
serve society. Among its other activities, the Conference Board prepares and purveys
economic indicators that are useful to investors and other forecasters.

The Conference Board’s three economic indicators are each computed monthly as weighted
averages of the component numbers listed in Table 5. The component numbers used in each
of the economic indicators are not entirely dependable indicators when observed alone
because they do not always turn in the right direction, and their lead times vary. The
Conference Board explains that its economic indicators are “constructed to summarize and
reveal common turning point patterns in economic data in a clearer and more convincing
manner than any individual component — primarily because they smooth out some of the
volatility of individual components.” Figure 10 illustrates how two different economic
indicators fluctuate through two business cycles.

TABLE 5 – Components of Conference Board’s Leading, Coincident, and Lagging

Indicators of U.S. Business Activity

A. Ten leading indicators used to create the Leading Economic Indicator (See the
solid blue curve in Figure 10.)
1. Stock prices lead business activity in the U.S. by 3 to 11 months.
2. Initial claims for unemployment insurance.
3. Manufacturers’ new orders for consumer goods and materials industries.
4. Fraction of companies reporting slower deliveries.
5. New orders for non-defense capital goods.
6. New private housing units authorized by local building permits.
7. Yield curve: The spread between 10-year T-bond yield and the federal funds rate.
8. Average weekly hours worked by production workers in manufacturing.
9. Growth rate in the M2 money supply.
10. Index of consumer expectations.
B. Four coincident indicators used to create Coincident Economic Indicator (Red
dashed curve in Figure 10)
1. Employees on nonagricultural payrolls.
2. Personal income less transfer payments.
3. Index of industrial production.
Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 22
 4. Manufacturing and trade sales.
C. Seven Lagging indicators used to create the Lagging Economic Indicator (Not
graphed)
1. Average duration of unemployment.
2. Ratio of trade inventories to sales.
3. Change in index of labor cost per unit of output.
4. Average prime interest rate charged by banks.
5. Commercial and industrial (C&I) loans outstanding.
6. Ratio of consumer installment credit outstanding to personal income.
7. Change in consumer price index (CPI) for services.

Source: http://www.conference-board.org/data/

FIGURE 10 – A Leading and a Coincident Economic Index (CEI) for the U.S. Economy

The dashed red line in Figure 10 is the Conference Board’s coincident economic indicator
(CEI), it peaks when the business cycle peaks. The solid blue line in Figure 10 is the leading
economic indicator (LEI), which turns downward months before the recessions begin. This
dependable signal is easy to interpret. Unfortunately, the leading economic indicator issued an
erroneous sell signal in 1966-7 (not shown here), when it turned down sharply and no

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 23
recession followed. This is the reason investors should consult different leading economic
indicators for confirmation before issuing orders to buy or sell.7

The yield curve provides another tool to help investors forecast the turning points in stock
market price indexes.

6B – SLOPE OF THE YIELD CURVE

A yield curve is a graphical relationship between the yields-to-maturity (YTMs) and years-to-
maturity for a group bonds that have equal default risk and all exist at the same time. Figure
11 illustrates a hypothetical yield curve for U.S. Treasury bonds. Since none of the 300
outstanding U.S. Treasury bond issues are ``likely to default, their primary difference is in
their maturities. Furthermore, the market for U.S. Treasury bonds is a very liquid market. For
these reasons, the issues of U.S. Treasury bonds that are outstanding on any given day may be
used to construct a yield curve representing credit conditions in the U.S. on that day.

FIGURE 11 – Upward Sloping Hypothetical U.S. Treasury Yield Curve at an Instant in

Time

7
The Organization for Economic Cooperation and Development (OECD) also prepares an index of
leading economic indicators that is updated monthly and is freely available at the OECD’s web site.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 24
It is well known that the slope of the U.S. Treasury yield curve is useful in forecasting gross
domestic product (GDP) and recessions.8 The yield spread between the yields-to-maturity
(YTMs) from intermediate-term Treasury bonds and short-term Treasury bills furnishes an
insightful measure of the slope of the yield curve.

𝑨 𝑻𝒓𝒆𝒂𝒔𝒖𝒓𝒚
𝒀𝑻𝑴 𝒇𝒓𝒐𝒎 𝟑 − 𝒎𝒐𝒏𝒕𝒉 𝒀𝑻𝑴 𝒇𝒓𝒐𝒎 𝟏𝟎 − 𝒚𝒆𝒂𝒓
( 𝒃𝒐𝒏𝒅 𝒚𝒊𝒆𝒍𝒅 ) = ( ) −( ) (4)
𝑻 − 𝒃𝒊𝒍𝒍𝒔 𝒕 𝑻 − 𝒃𝒐𝒏𝒅𝒔 𝒕
𝒔𝒑𝒓𝒆𝒂𝒅 𝒕
The yield spread defined above measures the segment of the yield curve that is most useful for
forecasting. If this yield spread is positive, the yield curve is said to slope downward, even
though other segments of the yield curve might slope upward. If the yield spread is negative,
the yield curve is said to slope upward. Figure 12 illustrates two yield curves that existed
before and after the December 2007-June2009 recession. The downward slope in the short-
term segment of the January 2007 yield curve correctly forecasted the forthcoming recession
eleven months before it began. And, the upward slope of the short-term segment of June 2009
yield spread correctly forecasted the end of the recession and the expansion that followed.
Yield curves like those in Figures 11 and 12 are updated daily and published in financial
newspapers, financial magazines, and are freely available on the internet.

8
GDP predictive power has been documented by C. R. Harvey, “Forecasts of Economic Growth
From the Bond and Stock Markets,” Financial Analysts Journal, September-October 1989, pages
38-45; A. Estrella and G. A. Hardouvelis, “The Term Structure as a Predictor of Real Economic
Activity,” Journal Of Finance, Volume 46, 1991, pages 555-576; and others. Recession predictive
power has been documented by A. Estrella, “Why Does the Yield Curve Predict Output and
Inflation?” The Economic Journal, Volume 46, 2005, pages 722-744; M. Chauvet and S. Potter,
“Predicting A Recession: Evidence From the Yield Curve,” Journal of Forecasting, Volume 24,
2005, pages 77-103; A. Ang, M. Piazzesi, and M. Wei, “What Does the Yield Curve Tell Us About
Growth?” Journal of Econometrics, Volume 131, 2006, pages 359-403; G. D. Rudebusch and J. C.
Williams, “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve,”
Working Paper 2007-16, Federal Reserve Bank of San Francisco, July 2008; and others.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 25
FIGURE 12 – Two U.S. Treasury Yield Curves Existing Before and at the End of the
December 2007-June2009 Recession

7. SPECULATIVE BUBBLES

A speculative bubble is an emotional epidemic. Speculative bubbles are also called price
bubbles, economic bubbles, and market bubbles. The Nobel Prize winning Professor Robert
Shiller defines a speculative bubble to be

a situation in which news of price increases spurs investor enthusiasm which spreads by
psychological contagion from person to person, in the process amplifying stories that might
justify the price increases and bringing in a larger and larger class of investors, who, despite
doubts about the real value of the investment, are drawn to it partly through envy of others’
successes and partly through a gambler’s excitement. 9

Bubbles are a challenge to those who believe that market assets are priced efficiently. Bubbles
are difficult to identify as they develop because the true underlying value of most assets is
unknowable. As a result, an asset’s value and the price cannot be easily compared to

9
Robert J. Shiller, Irrational Exuberance, Second Edition, Princeton University Press, 2005,
page 2.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 26
determine whether the asset is over-priced or under-priced. Bubbles are typically identified in
retrospect, after the prices of many assets collapse simultaneously.

Economic contractions and expansions occur when institutions and individuals change their
assessments of the economic environment, and bubbles and crashes result when these
changes occur sooner than expected. In particular, a market bubble develops when the price
of a market asset reaches temporarily high levels that are sustained more by investor
enthusiasm than by the underlying value of the asset. After the temporary nature of a bubble
is widely recognized, it ends in a market crash. Recent examples of bubbles include: (1) the
brief world-wide stock market crash that occurred in October 1987, (2) the dot.com
technology stock market bubble in the US from 1995 to 2000, and, (3) the US home price
bubble of 1996 through 2011 that set the stage for a deep recession called the sub-prime
mortgage crisis.10

The following six step sequence outlines the development and collapse of a market bubble.
(Step 1) The initial development of a market bubble is caused by a significant change that
awes some investors. Recent examples include the rapid and widespread adoption of the
internet during the late 1990s, or the prevalent belief (particularly between 1996 and 2006)
that U.S. home prices would continue to rise forever.
(Step 2) The rapid expansion of credit demanded by over-eager investors causes the bubble to
inflate further.
(Step 3) Rapidly inflating prices seem to lend credence to investors’ enthusiasm and stimulates a
bidding war.
(Step 4) The price inflation continues as yet another wave of investors with “a dollar and a
dream” push prices above their rational economic values. Valuation yardsticks such as price-
earnings ratios, cash dividend yields, the market price to book value ratio, rental yields on real
estate, and mortgage foreclosure rates go unheeded while market prices continue to surge
upward irrationally.
(Step 5) Public euphoria starts fading when the bubble runs out of new buyers. After the prices
of the assets level out a growing eagerness to sell causes some investors to begin liquidating
their speculative holdings before the inflated prices of the assets begin to collapse.
(Step 6) Fear of collapsing asset prices feeds on itself, becomes widespread, and leads to panic
selling as the bubble bursts. Market prices fall off a cliff.

A collapsing bubble in a nation’s real estate market, stock market, or other major market can
cause a widespread slowdown in business activity, and, might lead to a national recession, or
even a depression. Some crises reach world-wide proportions. For example, the sub-prime
mortgage crisis began with a peak in U.S. home prices in July 2006 and, then, the U.S. economy
entered a recession that morphed into an unusually long world-wide recession and painfully
slow recovery.

8. FOCUSING ON AN INDUSTRY

10
The preceding bubbles involve varying degrees of mob psychology and are unlike the May 6,
2010 Flash Crash in the US stock market, which was caused by technological problems.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 27
Companies competing to make a single product comprise an industry. Many industries have
discernable life cycles based on the life cycle of the industry’s product. The life cycle of a
product or an industry can be helpful when estimating the growth rate for that product or
industry. Figure 13 suggests a hypothetical life cycle model that can be customized to fit
several different industries and products.11

FIGURE 13 - A Hypothetical Product or Industry Life Cycle

Each different industry has a unique life cycle that must be estimated carefully. Faddish
products (for example, hit songs) can have life cycles that are measured in months. In
contrast, stable consumption products (for instance, Coca-Cola) can have life cycles that span
decades. It is worthwhile to invest significant resources in estimating an industry’s life cycle
because the growth rate suggested by the life cycle model is an important determinant of the
values of the common stocks issued by the corporations in the industry. The analytical
approach to forecasting, like the one illustrated in Figure 13, leads to better growth forecasts
than simply forecasting a single growth rate.

9. CONCLUSIONS

11
For empirical estimates of some product life cycles see L. Kamran Bilir, “Patent Laws, Product
Life Cycle, and Multinational Activity,” American Economic Review, July 2014, Vol. 104, No. 7,
pages 1979-2013.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 28
 “Buying low and selling high” is the goal of many investors. Since security prices fluctuate
continuously, knowing when to buy and when to sell is a very valuable skill. In other words,
timing the market’s moves is an important part of investment management.

U.S. stock price fluctuations contain a cyclical component. This is because some clever
investors can foresee recessions and they sell their stocks in anticipation of the falling stock
prices. Likewise, cleverly anticipated business expansions generate stock purchases that
cause bullish stock market activity. Such expert market timing skills cause stock price indexes
to be leading indicators of business activity in the manufacturing sector of the U.S. economy.
Studying these trading patterns is worthwhile because stock prices always start crashing
several months before a recession begins. Unfortunately, sometimes the U.S. stock market
crashes and no recession follows. The October 1987 stock market crash was a fluke which
demonstrates that not every stock market crash is the precursor of a recession.

The largest stock price declines lead the downturns in U.S. business activity by one to thirteen
months. If an investor can forecast business activity in the U.S. more than one to thirteen
months ahead, this economic forecasting skill will enable the investor forecast the stock
market’s direction. To develop market timing skills, active investors should study
macroeconomic data and the business cycle.

Investing in a market that is inflated by a temporary bubble is like walking on quick sand
because, in both cases, support can collapse unexpectedly. Stated differently, before investing
enthusiastically in an inflating market, investors should pause to determine what will sustain
the advancing prices.

Discerning the business cycle is complicated because stock price fluctuations also contain an
industry component. Many industries or products are moving through life cycles that have
asset pricing implications. In addition, at any point in time, some industries will offer better
investment prospects than other industries. Analyzing industry or product life cycles
facilitates making profitable market timing decisions.

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 29
Outline of Market Timing

1 - DOLLAR COST AVERAGING .................................................................................................... 2

EXAMPLE 1: Dollar Cost Averaging (DCA)............................................................................... 2
2 - THE BUSINESS CYCLE ............................................................................................................... 3
Figure 1A – Hypothetical Peaks and Troughs in the Business Activity .................................. 4
FIGURE 1B - Business Cycles and Stock Price Cycles .............................................................. 4
TABLE 1 - Statistics Measuring the Length of Recessions, Expansions, and Complete
Business Cycles in the U.S., 1919-2011 ..................................................................................... 5
FIGURE 2 – Gross Domestic Product, 1972-2017 .................................................................... 7
FIGURE 2A – Gross Domestic Product in U.S. Dollars* ............................................................ 7
FIGURE 2B – Annual Growth Rates in GDP, in percentage changes* ..................................... 7
1. 2A - THE DEPRESSION ....................................................................................................... 8
2. 2B – THE FACTORS OF PRODUCTION ARE CYCLICAL .................................................... 8
FIGURE 3 – U.S. Unemployment Rate, 1972-2017, in percentages ........................................ 9
FIGURE 4 - Capacity Utilization Rate in the U.S., 1972-2016 ................................................ 10
3. 2C – PRICES AND INTEREST RATES ............................................................................... 10
𝐑𝐚𝐭𝐞 𝐨𝐟 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 = 𝑪𝑷𝑰 𝒊𝒏 𝒎𝒐𝒏𝒕𝒉 𝒕 + 𝟏 − (𝑪𝑷𝑰 𝒊𝒏 𝒎𝒐𝒏𝒕𝒉 𝒕)(𝑪𝑷𝑰 𝒊𝒏 𝒎𝒐𝒏𝒕𝒉 𝒕)
(1)
1
1
FIGURE 5 – Inflation Rates and Six Month U.S. T-Bill Yields, in Percentages, 1972-2017 . 11
4. 2D – PERSONAL CONSUMPTION EXPENDITURES ........................................................ 12
Eqn.(2) below sums up the four major components of the annual income of U.S. A nation’s
income is also called its gross domestic product (GDP). In 2010, for instance,
consumption expenditures comprised 70.6 percent of the nation’s annual income, or GDP.
.................................................................................................................................................... 12
FIGURE 6 – Personal Consumption Expenditures, 1972-2016............................................. 13
3 – THE SUBPRIME MORTGAGE CRISIS .................................................................................... 13
TABLE 2 - Who Is To Blame for the Sub-Prime Mortgage Crisis? ......................................... 15
4 - FEDERAL ECONOMIC POLICIES ............................................................................................ 17
FIGURE 8 – Total Federal Deficits and Surpluses .................................................................. 17
5. 4A – THE U.S. TREASURY DEPARTMENT ....................................................................... 18
6. 4B – THE FEDERAL RESERVE SYSTEM .......................................................................... 18
5 - THE STOCK MARKET: A LEADING INDICATOR ................................................................ 19
FIGURE 9 – Standard and Poor’s 500 Stocks Price Index, 1970-2015 ................................. 20
7. 5A – GETTING CLAWED BY BEARS ................................................................................. 20
TABLE 3 - HPRs from Stocks and Bonds during Nine Recessions, 1951 – 2009 ................. 20
8. 5B - RIDING BULLS ........................................................................................................... 21
TABLE 4 – Stock Market Recoveries after Nine Recessions, 1951 – 2010 .......................... 21
6 – LEADING ECONOMIC INDICATORS..................................................................................... 22
9. 6A - THE CONFERENCE BOARD’S LEADING ECONOMIC INDICATORS ....................... 22
TABLE 5 – Components of Conference Board’s Leading, Coincident, and Lagging
Indicators of U.S. Business Activity ......................................................................................... 22
FIGURE 10 – A Leading and a Coincident Economic Index (CEI) for the U.S. Economy ..... 23
Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 30
 10. 6B – SLOPE OF THE YIELD CURVE .................................................................................. 24
FIGURE 11 – Upward Sloping Hypothetical U.S. Treasury Yield Curve at an Instant in Time
.................................................................................................................................................... 24
𝑨 𝑻𝒓𝒆𝒂𝒔𝒖𝒓𝒚 𝒃𝒐𝒏𝒅 𝒚𝒊𝒆𝒍𝒅 𝒔𝒑𝒓𝒆𝒂𝒅𝒕 = 𝒀𝑻𝑴 𝒇𝒓𝒐𝒎 𝟑 − 𝒎𝒐𝒏𝒕𝒉 𝑻 − 𝒃𝒊𝒍𝒍𝒔𝒕 −
𝒀𝑻𝑴 𝒇𝒓𝒐𝒎 𝟏𝟎 − 𝒚𝒆𝒂𝒓 𝑻 − 𝒃𝒐𝒏𝒅𝒔𝒕 (4) ......................................................................... 25
FIGURE 12 – Two U.S. Treasury Yield Curves Existing Before and at the End of the
December 2007-June2009 Recession ..................................................................................... 26
7. SPECULATIVE BUBBLES ......................................................................................................... 26
8. FOCUSING ON AN INDUSTRY ................................................................................................. 27
FIGURE 13 - A Hypothetical Product or Industry Life Cycle ................................................. 28
9. CONCLUSIONS ............................................................................................................................ 28

Teaching Note - Market Timing – Prof. J. C. Francis – Supplement to textbook Ch. 12 - Page 31