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Yola Edwards

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Round and round you go

Yola Edwards

Successful cycle investing requires that you know where you are in the economic cycle and choose the sector that best fits the changing climate. The official U.S. recession bottomed in November 2001, but the stock market didn't bottom until March 2003. To ward off potential deflation and to try and re-ignite the U.S economy the U.S. Federal Reserve Board cut interest rates and by mid-2003 they were at a 40-year low with the prime rate at 4 per cent and the Fed Funds rate registering 1 per cent. The Fed kept rates low until mid-2004 when they started to raise rates to control the economic expansion, which subsequently followed. In January 2006 the Fed Funds rate was 4.25 per cent and the prime was 7.25. First quarter 2006 Gross Domestic Product (GDP) data revealed an annualized growth rate of 5.6 per cent. Fearing overheating, the Federal Reserve continued to tighten and on June 29 raised Fed Funds rate by 25 basis points to 5.25 per cent the and the US prime rate now stands at 8.25 per cent. Now however, there is some fear that we're facing a global slowdown. On July 28 the U.S. Commerce Department reported second quarter GDP growth slowed to a 2.5 per cent annual rate, which was slower than the 3.2 per cent consensus number expected, fueling speculation that the Federal Reserve Board may have tightened too much and that the June rate hike, may have been its last in the 2-year-year-old rate raising campaign.

So are we at the end of the cycle or just pausing? Is it too late to buy cyclical stocks or not? Again it's a matter of debate and that's what makes a market.

Identifying cyclical stocks is fairly easy as they tend to be the nuts-and-bolts companies of the economy such as heavy industry and durable goods, metals, automobile manufacturers, airlines, furniture, steel, paper, heavy machinery and also include luxury items such as sectors hotels and expensive restaurants. Cyclical stocks tend to be more volatile than growth stock as they are exceptionally sensitive to economic changes. During boom times these stocks will thrive, but during economic slowdowns they are prone to potentially drastic earnings losses, which in turn cause dramatic share price swings. Good growth stocks will continue to increase earnings even through recessionary times.

Cyclical stocks are the essence of the "buy-low, sell-high" mantra. You can make a lot of money if you invest at the bottom of the down cycle, just ahead of an upturn, but you'll find that it requires courage to do so as you'll be investing against popular opinion since you'll be buying these stocks when their business is at its worst, showing negative earnings in many cases, and selling the stocks when the business environment is good since cyclical stocks usually turn positive or negative months in advance of supportive economic or industry data. However, before buying a cyclical stock, look for the industry that looks ready for a bounce and select the strongest stock within it. Given that cyclical stock markets usually last from one to four years, timing plays an important role in investing in them. However, there is even timing among cyclical groups. Petrochemicals, cement, pulp and paper and other commodities are usually the first group to move. Then toward the end of the cycle you see movement in technology, and consumer groups such as clothing, airlines, and the automobile industry.

One money manager, Fred Pynn of the Bissett Canadian Equity Fund believes the end of the commodity market's cycle is just about upon us and has sold off all of the funds mining stocks and is underweight in the energy sectors with a 22 per cent weighting.

However, Chief Investment officer for Empire life, Deborah Frame believe that there is "an insatiable demand for our energy" and her portfolio maintains a 30 per cent energy weighting.

Indeed technical charts reveal that we are undoubtedly in a mature commodity market as we are between 50 per cent and possibly two-thirds of the way through the current cycle. Although there is still the potential for added growth, investing in the commodity sector is not without its risks at this stage of the game.

The NASDAQ has rebounded from its 2002 lows of 1,109, but it's still trading 60 per cent below its March 2000 high of 5,132. Typically, cyclical technology stocks such as semiconductors advance when the economic recovery is certain and technical analysis suggests that this is just the time to get involved.

Of particular interest is Intel. Since the beginning 2006 the stock is down 32.4 per cent and its share price is back to levels last witnessed in 2003 and is trading below its 200-day moving average (MA). However, the stock has traced out a double bottom over the past month and the moving average convergence/divergence oscillator (MACD) has been diverging positively. The stock obviously has work ahead of itself but it appears ready to rally to first resistance at $19.37 (U.S.). A close above that should see the stock rally fairly quickly to the patterns technical measurement of about $21.90 over the next month. From there the stock will face stiff overhead resistance up to $25 due to the US$3 falling window gap which occurred in January. This just might be the turning point for the stock and from a risk reward point of view it appears to be favourable for risk tolerant investors.

Yola Edwards is a contributing writer and technical analyst for Bell Globemedia Interactive, providing options and technical analysis research on a variety of North American equities.

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