Business cycles — expansion, peak, contraction (recession), and trough — affect which asset classes and sectors tend to outperform. During expansions, cyclical sectors (industrials, consumer discretionary, technology) tend to lead. During contractions, defensive sectors (utilities, consumer staples, healthcare) tend to hold up better. Understanding where the economy is in the cycle helps advisers make tactical asset allocation adjustments.

Leading economic indicators (stock prices, building permits, consumer confidence, manufacturing orders) predict future economic activity. Lagging indicators (unemployment rate, interest rates, business loan volumes) confirm trends after the fact. The Conference Board's Leading Economic Index (LEI) is a commonly cited composite of ten leading indicators.

Key Terms:

• P/E ratio (Price-to-Earnings): Market price per share divided by earnings per share; primary valuation metric for equities.
• P/B ratio (Price-to-Book): Market price relative to book value (net assets) per share; below 1.0 may signal undervaluation.
• Debt-to-Equity ratio: Total debt divided by total equity; measures financial leverage and solvency risk.
• Return on Equity (ROE): Net income divided by shareholders' equity; measures management's efficiency in generating profit from equity.
• Present Value (PV): The current worth of a future cash flow discounted at a specified rate.
• Future Value (FV): The value of a current investment after compounding over a period at a given rate.
• Discount rate: The rate used to convert future cash flows to present value; reflects risk and opportunity cost.
• Business cycle: The pattern of economic expansion and contraction; phases are expansion, peak, contraction, and trough.
• Leading economic indicator: Data point that changes before the economy changes; used to predict future economic activity.

Quiz Questions:

Q1. A company has a stock price of $45, earnings per share of $3, and book value per share of $15. Which of the following is correct?

A) P/E ratio = 15, P/B ratio = 3 B) P/E ratio = 3, P/B ratio = 15 C) P/E ratio = 45, P/B ratio = 5 D) P/E ratio = 0.07, P/B ratio = 0.33

Answer: A — P/E = $45 / $3 = 15. P/B = $45 / $15 = 3. These are the two most fundamental equity valuation ratios. A P/E of 15 is considered moderate for most markets; a P/B of 3 means investors pay $3 for every $1 of net book value.

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Q2. A client asks which type of economic indicator would have signaled the start of a recession before it was officially declared. The BEST answer is:

A) Lagging indicators such as the unemployment rate B) Leading indicators such as new building permits and stock prices C) Coincident indicators such as personal income D) Real GDP growth, which is a lagging indicator

Answer: B — Leading indicators change before the broader economy changes. Stock prices, new building permits, and consumer confidence are leading indicators that can signal an impending recession before the National Bureau of Economic Research (NBER) officially declares one. Lagging indicators like unemployment confirm trends after the fact.

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