This model shows how sectors respond at different stages of the economic cycle. The chart is organized as follows: The outermost ring, labeled "The Economy" is green when the economy is expanding, yellow when the economy is coasting and red when the economy is slowing or shrinking. (Read the chart in a clockwise direction.)

The next ring shows how the Federal Reserve responds to the state of the economy. Typically, Fed policy is accommodative (green) when the economy is growing slowly or in recession, and is more inclined to lower interest rates and increase growth in the money supply. We are exactly at that point right now. U.S. gross domestic product -- a key economic indicator -- grew at a rate of 1.4% in the fourth quarter of 2000, the lowest since the second quarter of 1995. January's Purchasing Manager's Index figures, out today, confirm the slowdown. We have already had two cuts in the Fed funds rate in the past month, and market expectations are for another cut at the March meeting.

These sectors are most closely correlated with expansion and contraction of the economy:

• Capital goods (factory machinery, aircraft)
• Consumer cyclicals (automobiles, housing)
• Technology (computers, telecommunications)
• Transportation (airlines, shipping)

As the economy expands, there's more demand for goods, and thus more demand for capacity to make and deliver goods. Also, with falling unemployment and rising incomes, consumers are more likely to spend on cars and houses.

Because the stock market generally anticipates economic conditions by about six months, the best time to buy companies in these sectors is when economic growth has slowed and interest rates are falling (i.e., right now). The worst time to buy these companies is when a fast-growing economy starts to slow, as we saw in 2000.

These sectors do best toward the end of an expansion:

• Basic materials (steel, aluminum)
• Energy (oil, natural gas)

When U.S. and world economies are running fast, demand outstrips supplies of basic materials and energy. Prices rise accordingly, boosting the stock prices of related companies. However, the window where you can take advantage is short. Once economies slow, prices on basic materials fall back to the cost of production, and stock prices of these companies fall also.

These sectors do best when the economy has slowed:

• Financial services (banks, insurance companies)
• Utilities (ignoring California utilities right now)

These companies have higher-than-average dividend yields, so they become more attractive to investors seeking safety. The main boost comes from falling interest rates in a slower economy -- the dividends are valued higher, and lower rates often boost bank earnings (both sectors did well in 2000). Stock prices in these sectors fall when rates are rising, so they're best to avoid in the late part of an economic expansion, especially when the Fed is boosting the Fed funds rate.

These sectors do best heading into recession, and stock prices here are often inversely correlated with the state of the economy:

• Consumer staples (food, toothpaste)
• Health care (drugs, HMOs)

Regardless of the state of the economy, consumers still buy food and health care. So while the earnings of these companies don't expand much during a recession, investors seek these companies anyway because of the reliability of their earnings. However, once the economy starts to expand again, these companies are sold in favor of technology, capital goods, etc. That's what we're seeing now.

Economic cycles in the U.S. last about five years on average, so the current cycle, which started in 1990, is a bit unusual. Also, we expect the current slowdown to be fairly short, with GDP growth rates heading back above 3% by the third quarter. So, at my money management firm, we are rebalancing our portfolios away from safety (especially health care, where we're overweighted) back toward growth (technology especially, but also retail stocks and capital goods). We're keeping our financial services positions flat, and shying away from energy stocks for a while.

The chart obviously simplifies a lot of detail but should give you a graphical understanding of the relationships between sectors and the state of the economy. You can also go the other way -- looking at the relative performance of the sectors to see where the economy is heading. You can do this by viewing Smart Money's Market Map or looking at Stock Chart's sector performance charts.

The US economy goes through a cycle of expansion and contraction which is variable over a three to seven year time frame. The core real rate of growth in the US economy is about 2.5%/year, but the quarter by quarter numbers can be as high as 5% or as low as -1%. Two quarters of negative economic growth are the official definition of an economic recession. The Federal Reserve Bank's charter is to maintain the currency as a store of value (i.e. keep inflation low) and to promote the growth of the economy.

In principle, these goals should be easily achieved - increase the money supply at about the same rate as growth in the overall economy. In practice, many factors make this task equivalent to driving a car down a country road at night with no headlights and a loose steering wheel. The Fed often finds out after the fact that policy has been too loose or too restrictive. As a result, the economy veers from expansion (with risk of inflation) to contraction (with inadequate growth.) Different investment vehicles perform better or worse during different parts of the economic cycle. For example, long dated treasury bonds perform well when the economy contracts because the Fed Reserve loosens monetary policy (which causes bond yields to fall and bond prices to rise.) Cyclical stocks such as car companies tend to perform best in the early part of economic expansions (as consumers make purchases deferred when the economy was weaker.)