Devoted to understanding the basics and fundamentals of investing

I am going to start today a series on business cycles.  I will look at it from various points of view.

Economies around the world are subject to various cycles.  I will start my discussion of the economy cycle at a recession.  A recession is a period when the economy has been shrinking (in the case of the US economy a period of six month).   During the recession companies repair balance sheets by retiring debt and stretching out maturities.  They improve operations by laying off workers and closing inefficient plants.  As the economy cools, inflation falls.  The Fed can begin to reduce interest rates to stimulate the economy. 

This part of the cycle favors bonds.  It is a good time to lengthen the duration of your bond allocation.  As interest rates fall, the price of your bonds will go up.  The longer the duration, the greater the price appreciation you will realize.  The long-term bond portfolio where I work earned 33% in the year the recession ended.

For equities, at the first sign of recession, you should become defensive.  You can do this by reducing the beta of the portfolio to under 1.  You can also increase the dividend yield of the portfolio.  Both strategies will make the portfolio less sensitive to falling stock market prices. 

The most powerful tool at your disposal is to change your asset allocation.  You would increase bonds and reduce equities and cash.  This will greatly reduce the overall risk in the portfolio.

Tomorrow I will discuss a period of recovery coming out of a recession.