The ‘Business Cycle’ framework

This post is a follow-up to one of my earlier posts, ‘Stop reading the news thoughtlessly and develop a macro framework’ which had generated some interest among WSO users. In this post, I’ll briefly introduce the perspective of ‘business/economic cycle’ and then show how investors can draw practical conclusions from this concept using publicly available data.

Business Cycles

The idea behind business cycles is that an economy does not grow in a linear fashion but fluctuates around a long run growth rate – these fluctuations are known as economic expansions and recessions. The core idea behind this theory was introduced perhaps as early as 1819 but it was Joseph Schumpeter (1883-1950) who first identified the four stages that characterise a typical Juglar economic cycle of 7-11 years (taken below from Wikipedia):
1. Expansion (increase in production and prices, low interest-rates)
2. Crisis (stock exchanges crash and multiple bankruptcies of firms occur)
3. Recession (drops in prices and in output, high interest-rates)
4. Recovery (stocks recover because of the fall in prices and incomes)

Business cycle is the holy grail of macro forecasting/investing. If you can successfully time the next peak or trough, then you do not need to do anything else for a living – in fact, getting this call right just once or twice in your lifetime can mean enough fortune for the rest of your life. It is no wonder then, that an army of sell-side analysts (meaning analysts employed by brokerage firms such as Merrill, JPM, Goldman etc.) and buy-side outfits (meaning hedge funds, asset managers, insureres, pension firms and the like.) indulge in making such predictions. Most of the so-called bottom-up ‘value investors’ (meaning those who focus on analysing companies / industries rather than the broader economy – Warren Buffett being the prime example) dismiss macro forecasting as too hard / impossible. However, even ‘dyed in the wool’ value-investors such as Howard Marks ackowledge the importance of getting a rough sense on where we are in the business cycle (even though Marks dismisses macro forecasts on timing the next phase of the cycle). For completeness, I’d also state the obvious that Modern Portfolio Theory largely dismisses the notion that investors can generate consistent above-average returns by indulging in such forecasts.

Where are we?

So that’s the background – now lets dive into the interesting part: where are we in the current business/economic cycle, what can the future be reasonably expected to look like and what does this mean for investing? To do this, we need to first understand what causes business cycles. There are many theories behind this but one that is popular on Wall Street involves what is known as ‘credit cycle’ – this says that expansions and contractions in credit/debt lead business cycle troughs and peaks. The theory puts banks at the centre of economic activity and brings us to the slope of the ‘yield curve’ as a leading indicator of business cycles. Yield curve is the difference between long term and short term interest rates (10 year and 2 year being the most common – known as the 2s10s curve). An inverted yield curve is perhaps the single-best predictor of business cycle peaks and upcoming recessions – an inverted yield curve means that profits at banks are shrinking (because banks borrow short term in the form of deposits and lend long term in the form of loans) which causes them to retrech credit leading to a crunch. The humble yield curve has predicted all post-war recessions with only one false signal. So what is the yield curve telling us now?


Figure 1: Yield Curve: US2s10s curve (difference between interest rate on 10yr treasury and 2yr treasury)
Source: Federal Reserve Bank of St. Louis

As shown in Figure 1, the 2s10s yield curve is at 1.6% and is firmly in the positive territory. This indicates that the US is firmly in the expansion stage of the business/economic cycle. The shaded regions in the chart show recent economic recessions in the US and you can see that their arrival was well indicated by an inverted yield curve (with a lead time of 5-16 months and of 12 months on average). Incidentally, I have taken this data from the website of Federal Reserve Bank of St. Louis (the tool is known as FRED) and this is a publicly available data that anyone can access. There are free online tutorials by NYU Stern which explain how to retrieve and monitor a host of data using the FRED website.

So the most reliable indicator of economic cycles is signalling ‘all-clear’. In fact, Ed Hyman, who has been ranked as the #1 Economist in the Institutional Investor survey (the famous ‘II’ survey) said in a recent interview (you can listen to the podcast here) that he sees the US as being in the early stages of economic recovery and expects this cycle to go on for at least another five years.

We can see signs of this robustness in other indicators: employment is fairly robust with the widely watched Non-Farm Payrolls data firmly above 200,000 (Figure 2) and unemployment declining to 5.3% in June (blue line in Figure 3).


Figure 2: US Non-farm payrolls (NFP)
Source: Federal Reserve Bank of St. Louis


Figure 3: US Unemployment rate
Source: Federal Reserve Bank of St. Louis

Similarly, the residential market seems to have recovered with housing starts back above the psychological one million units in all of the last three months. Consumers have got an additional boost from low oil prices and the consumer confidence index has generally stayed high in recent months (this is important because the consumer sector is the most important part of the US economy). So does this mean that the economy will hum along fine and investors will continue to get rewarded for taking risks?

Risks can occur on the road to recovery

Not so fast. There are many risks to this recovery: one risk that many bears highlight is the upcoming Fed rate hike (widely expected to occur sometime this year). This will be the first rate hike in ten years and the risk is that it will quickly undo the on-going ‘recovery’ which has itself been driven by extraordinary monetary policy (quantitative easing in addition to zero interest rates and ultra-easy forward guidance). The other risk is the rise of, what is commonly known as, ‘late-cycle’ behaviour in the financial markets – M&A volumes are back to all-time highs, companies are issuing debt to buyback shares increasing corporate leverage, covenant-lite loans are reaching new highs (indicating an aggressive, ‘reach for yield’ behaviour among the investing class) and the share of weak ‘B or below’ rated issuers among total corporate issuance is reaching levels that start signalling caution.

There are international factors to worry about as well. While the American economy bounced back neatly after the financial crisis, Europe has continued to stay mired in a low growth, low inflation/deflation environment with high unemployment and significant economic contraction among the peripheral economies (Greece being the chief among them). Europe affects the US most directly through interest rates, FX and inflation. Expectations of a US recovery causes the dollar to strengthen against the euro which leads to lower inflation in the US – in effect, ‘transporting’ the weak growth in Europe to the US. Apart from Europe, China has been another exporter of ‘deflation’ to the world in the recent years and the collapse in commodity prices last year has largely to do with subdued expectations on Chinese demand and investment growth.

The final risk lies with valuations. On a cyclically adjusted basis, US stocks P/E ratios are at above average levels and the on-going rally has been the third longest stretch in the post war period (a correction is defined as a 10% fall in S&P500 from peak to trough). So even if the US continues to expand, much of that expansion looks baked into equity prices. Other asset classes are at similar stretched valuations – bonds have been rallying in a straight line for the last 35 years (figure 4 below), taking the careers of many bond bears along the way. This has caused bond yields to reach historically low levels and the ‘all-in yield’ of junk bonds has plummeted along with treasury rates.


Figure 4: Will the 35-year bond market rally turn into a selloff?
Source: Federal Reserve Bank of St. Louis

So where does this leave us? Timing the next stage of the business cycle is a challenging (and some may say impossible) but rewarding task. If you are confident that a correction is due in the next few months then shorting S&P500 futures is good way to express that trade. You can buy put options instead but those on S&P just one year out will cost you five points upfront. On the other hand, if you believe (as Ed Hyman does) that this cycle has a few more years to run then equities are your best bet and you buy the dips. You can take a similar view on interest rates and on bond ETFs – Wall Street forecasters have been consistently wrong on the rally in rates that occurred during the last five years, so you may try your luck if you believe you can do a better job. In 2014, Wall Street forecasters (with the exception of HSBC) were wrong to a man on the direction (let alone the level) of interest rates.

Personally, I have found it useful to just have a rough sense of where we are in the business cycle. If nothing, this helps remind me that a lot of companies/trades are running along fine simply because we are in a bull-market. I will be very interested in knowing what you think about this concept and what your thoughts are in terms of where we are in the current cycle.

 

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