The downside risk is always at a minimum when you buy stocks at "deflated" prices or in industries which are currently in disfavor. The market is always in the habit of overbuying stocks of favored industries or overselling "deflated industries."

Actually, deflated industries are often just in the "down" cycle of the whole economy, especially when they are plagued by excess capacity. Earnings of the nation's basic industries have experienced periodic ups and down in line with general economy. Those stocks whose earnings tend to rise and fall with the ups and downs of the economy are identified as cyclical stocks.

They are mostly stocks of substantial companies in industries which were once growth industries but have grown up so that they form the major part of the total economy. They are stocks usually selling at modest prices in relation to the capital they have invested in the business and to their proved earning power.

Most of them are being handicapped by a substantial overcapacity, with an inevitable decline in the utility of their machinery and other assets. It does not follow, however, that these assets have lost their usefulness. The excess capacity is apt to be absorbed by an appreciable pick-up in the rate of the nation's economic growth.

A 5 to 8 per cent gain, for instance, in G.N.P. (Gross National Product) might bring the chemical industry, one of the industries with excess capacity, to over 90 per cent of capacity, and this will do wonders for profit margins. It is noteworthy that top fiscal policy makers of the Kennedy Administration have forecast a 10 per cent gain in G.N.P. in the next two years or so. Even without this projected substantial gain in G.N.P., the large companies of basic industries are expected to continue their cyclical growth in line with general business cycles; and there should always be opportunities if you know how to profit from them by studying the nature and patterns of these cycles.

During the postwar years, according to a study by Thomson & McKinnon analysts, a distinct cyclical pattern has been established, consisting on the average of a two-and-a-half-year rise followed by a one-and-a-half year decline. In 1949, 1953-54, 1958 and 1960, for example, our economy either was depressed or emerging from a recession, while the interim years were times of booming business and high corporate profits.

A new boom will probably be under way by 1962, carrying into 1963, as indicated by most major economic indicators.

A simple way of telling whether an economic boom is coming is devised by William Kurtz of Paine, Webber, Jackson and Curtis. In his Anticipating the Magnitude of Recessions and Recoveries, he saw a close relationship between industrial production, bank reserves and residential construction over the course of a business cycle. The combined effect of bank reserves and construction is said to have preceded the turns in actual industrial production in seventeen out of eighteen cyclical periods.

While no single index of business expectations can be used effectively without considering all known economic variables, economists have long recognized the strategic role  played by  money supply and construction in generating business cycles; they provide us with a convenient way of taking a pulse of coming private capital investments which are found to have been responsible for much of the postwar cyclical fluctuations.

Since the basic cyclical industries constitute the primary sources of the economy, they should be among the first to move in either direction when major economic indicators signal an upturn or downturn. Economic activity should be accelerating at the primary level before rising demand for end products can be met.

Among the basic industries are steels, machinery, machine tools, oils, chemicals, autos, coppers, nonferrous metals. Most cyclically oriented industries are generally candidates for substantial improvement in operations beyond the expectation for the economy as a whole.

The companies whose stocks are likely to go up the most during the period of recovery are generally the marginal ones, where the earnings improvement stands to be the greatest. These are companies which are capable of generating substantially higher profits in periods of greater demand.

The railroad industry should be among the chief ones to benefit from a turnaround in the business cycle. When the real turn comes in basic heavy industry, there will be the inevitable period of inventory accumulation. Railroad statistics are among the first indicators of improving industrial conditions.

Epitomizing U.S. heavy industry, the steels have long been considered feast-or-famine stocks and depend much upon their most important customer—the automobile industry, which consumes about 20 per cent of steel shipments.

It is always difficult to perfectly time the purchase of cyclical stocks. However, risks appear only limited if you know how to buy steel stocks at a low consumer inventory level from which there is not likely much further reduction and which should considerably reduce the industry's downside potential.

Another trick is to coordinate purchase with such events as labor contract negotiations, which will likely stimulate an upswing in demand.

Always favored are such leading firms as Bethlehem Steel, Jones & Laughlin and, of course, U.S. Steel, the last being the lowest cost major domestic steel producer. They stand to benefit most from continued technological advances in production and product improvement over the next decade, which may well compare favorably with such strides made during the last fifty years.

While highly cyclical, the automobile industry is believed to possess further growth prospects because of the generally rising basic demand for cars. In his 1960 analysis-forecast of the U.S. economy, economist Arnold H. Johnson stated that it would take 30 million additional cars—some 50 per cent more than now in use—to saturate the market. This estimate was based on the fact that 17 million families did not own a car at that time, and that 13 million might go to two cars. Moreover, according to Johnson, the number of youths reaching driving age has been rising fast.

The intermediate-term picture, however, looks far less promising because of the substantially added capacity since 1955. Moreover, the comparatively high profit margins which traditionally justified the relatively high market price of auto shares have dwindled appreciably due to the increased percentage of lower-priced and, therefore, lower-profit-margined compacts.

Aluminum issues are also cyclical because of the shifting demand from the building, electrical, automobile, aircraft and missile industries. While at the present time, U.S. capacity for the production of virgin aluminum probably exceeds the demand, many new outlets are in the offing.

The present overcapacity is the result o£ the enormous postwar build-up of facilities here and in Canada. Few industries have grown since the end of World War II as has the aluminum industry. Since the turn of the century, there has been a doubling of output every decade.

Further growth prospects for this light metal, however, are excellent because of its greatly broadened market. The volume of aluminum going into new houses has been increasing. The container field offers considerable promise for aluminum. In the automobile industry, aluminum stands to benefit from the trend toward compact cars.

With the expected continued growth of aluminum use at about 8 per cent a year, present overcapacity may well be temporary.

Textile issues are still another group which appear to be entering a more favorable cycle, with the potential to be magnified by its important technological and labor-saving developments of recent years. Its cyclical growth is expected to be further stimulated by President Kennedy's policy of allowing faster depreciation write-offs on some types of textile machinery. The extent of benefits inherent in this policy can be seen from one estimate that 70 per cent of all textile machinery now in use is obsolete. The faster write-offs could permit the industry to finance more readily purchases of new and improved equipment.

There is cyclical growth even in the most depressed industries, especially when their troubles are well publicized. The market potential for such situations are usually large if purchased near the bottom of a business cycle.

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