Profiting From the Business Cycle

Why is there a business cycle? Someone once noted that people could tolerate any condition except the possibility of one. This one condition is prolong periods of prosperity. Incredible as it seems, this observation contains more than just a kernel of truth, and helps to explain where we are in our current business cycle.

When the economy starts to recover from a stiff downturn, people are understandably doubtful about the tenacity of the young expansion. They hold back on their discretionary spending and their use of debt. As the upswing continues to gather force, people tend to become less risk averse. You might say that the greed factor becomes more prevalent.

As the upturn ages, people become more confident and think that the expansion will last indefinitely. (This has a similar ring to peoples’ attitudes towards real estate today.) Business people take on more debt to leverage their profit margins. The consumer will also be increasing their debt burdens to finance their growing consumption habit. This increase confidence of consumers is also reflected in their disregard of saving. Soon a point of no return is reached where the cost of servicing the debt is growing faster than consumers’ income. This scenario also holds true for over-indebted businesses.

Now the expansion starts to stall because businesses and consumers can not sustain this level of credit expansion. A period of credit liquidation ensues and a new downturn begins. The severity of the downturn depends on several factors. These include the oversupply of goods and services, the level of debt buildup, and government economic policies (namely tax and trade policies).

The business cycle will always be with us. You might say it is the result of the genetic make-up of mortals. No government policy or regulation can abolish it.

For argument purposes, let’s say it is possible to eliminate the business cycle. Then the question is–what is the price to be paid. What price you ask! Yes, there is always a price because the cardinal law of economics is–there is no such thing as a free lunch.

The price paid is lost opportunities and slower long-term economic growth. Downturns, recessions as they are called, have a beneficial purpose. Their purpose is to provide renewed liquidity to the business system. Think of it as the catharsis of the economic system. Recessions cleanse the system of marginal companies and transfer their resources to stronger more productive enterprises. They also force consumers to start saving more to pay-off some of their massive debts they have accumulated during the expansion. This sets the stage for the next upward expansion. Without recessions there would be stagnation.

Recessions can be painful for most, but a time of great opportunity for some. Downturns provide the opportunities for those clever individuals, who have the wherewithal (the liquidity), to purchase assets on the cheap. These assets are then transferred into more productive hands, and the economy benefits.

No matter how many rules or laws politicians put in place, the business cycle is here to stay. Your goal is to take advantage of swings in the cycle to gain market share.

Understanding the Business Cycle

Business Cycle or Economic cycle is a term that refers to fluctuations in the production and/ or economic activity over a period running into several months or years in an entire economy. Such variations happen around a growth trend that is long term. It involves a shift between expansion or boom periods and recession periods. The fluctuations are generally measured using real gross domestic product. Business cycles are said to be a certain type of fluctuation that is found in the cumulative economic activity of various nations that have their primary work in business enterprises. A typical cycle consists of expansions and contractions in economic activity. The business cycles can vary anywhere from one year to even a dozen years.

The Business cycle of a company indicates specific economic activity that has a bearing on the company’s operations at any given point in time. During the life of a company four points of business cycles are possible – economic upturn, peak, economic decline and recovery. It is evident that economic upturn is the most coveted state for all companies because it is indicative of continuous business growth and future growth prospects too. In this period sales are high and earnings are healthy. The company has surplus and has better profits. It is in a position to pass on benefits to employees and acquire assets. A company that is wise always knows that “economic upturn” cannot continue forever and plans for the possible downtrend period. Economic peak is when the company is at the pinnacle with good profits but there is hardly any scope for growth.

In the period of decline a business has lost customers to competition or recession trends; it might have made a wrong diversification decision and so on – it faces losses. Recovery phase is when the company starts moving up the ladder again to regain the lost glory.

Beware the Business Cycle

About 30 years ago, I came to the USA and had great difficulty finding a job as Civil Engineer. Most of my applications resulted in polite regret letters citing one reason or the other for the refusal. When I spoke to a friend (who had come here many years earlier), he told me that the reasons given in the letters were all nonsense. The real reason was that the companies had no jobs. I had committed the cardinal sin of arriving here during a business down cycle or economic contraction.  

At the time, I did not understand the full implications of what he said. Now however, after many years in the USA, I have lived through several ups and downs of the Economy and have a healthy respect for the Business Cycle. Further, I often hear about some acquaintances who have suffered heavy losses in their business start ups. These are hard working and intelligent people, but they started their business near the peak of a business cycle; consequently they paid almost the maximum price for purchasing their business, just before it was ready to go into a slump. Buying a business near an Economic cycle peak is a very risky move.

Different stages of the business cycle exhibit different characteristics-

Near the peak of a business cycle, you may observe the following:

Your commute takes longer (if you drive).

You have to park further and further from the train, (if you commute by rail).

You often have to stand in the train, bus or subway.

At the mall, parking may take several minutes to find.

Prices of groceries and gasoline go up almost on a weekly basis.

All your neighbors have purchased new, often bigger and luxury autos.

Your friends are putting up additions to their houses or remodeling their kitchens.

Handymen need 30 days notice for the smallest repair job.

People are very confident about the future.

Near the bottom (or trough) of a business cycle:

You often reach work early, because the commute is easier (if you still have a job).

You get comfortable seats in the train and good parking.

At the Mall, you park in under two minutes and the checkout is very quick.

The newspaper has many coupons for things you can actually use.

Repairmen are happy to come and give you a free Estimate for work.

People are gloomy about the future.       

So much for subjective observations. For more objective readings, an excellent source is the website of the National Bureau of Economic Research (NBER) at www.nber.org/cycles/. According to their studies, the last ten business cycles had an average duration of 67 months, with 57 months up and 10 months down. So roughly, we can say that we have 5 years of expansion followed by 1 year of contraction. Incidentally, the Economy last peaked in December 2007 and this was formally recognized in December 2008.

While the NBER readings are an excellent and authoritative source of information, their determinations are made several months after the peak or trough is over. If you are interested in anticipating a recession or recovery before it begins, the Stock market is an early predictor of a turn in the economy. For this, you can look at a chart of the stock market as represented by the S&P 500 index and superimpose the 150 day and 200 day averages. The averages are useful in smoothing out the day to day gyrations of the market and show the general direction, or trend of the market, as smooth lines. These lines serve as advance indicators. In an expanding economy, these lines have an upward slope. As the economy begins to weaken, these trend lines flatten out and gradually turn down. This is a fairly reliable sign that economic growth will soon turn negative. Several months later (say 9 to 18), these lines again turn up, signaling that the economy will soon be improving.

These trend lines can also be used as stock market entry and exit signals. In the 2000-2001, as well as the 2008 market meltdown, these signals could have saved the stock market investor from considerable losses, roughly 30-35% in each instance. So it pays to be aware of the Business Cycle.

Let me quote from the 1969 hit song “Spinning Wheel” by the pop group “Blood Sweat and Tears.”

“What goes up

must come down

spinning wheel

got to go around

talkin’ ’bout your troubles

it’s a cryin’ sin

Ride a painted pony

let the spinning wheel spin”

(Blood, Sweat & Tears, 1969)

In general, anybody who buys an economy-sensitive business or makes a large investment in the late stages of a business cycle, risks undergoing an experience involving “Blood, Sweat and Tears”, when the Economy does its next swan dive.