Analysis of Business Cycles
When things are going well in the economic cycle, people enjoy the boom because commodities are there in plenty, and consumers have the capacity to purchases everything they want, or at least most of them. But this situation does not last forever, sooner or later, it reaches a point where no more expansion is possible. And, like an elastic belt, things will start declining. That is the nature of a business cycle. This term, 'business cycle,' or otherwise economic/boom-dust cycle, is used to mean the fluctuations in production, trade, and general economic activities that affect an economy. Looking at the conceptually, we can say it is the rising and falling shift of GDP (Gross domestic product) levels. It represents that period of expansion and contractions in economic levels and business processes over a long-run trend.
Therefore, learning of the business cycle is one of the core subjects of macroeconomics. This is because the general performance of an economy affects the social aspects of life as well. When things are well, people will buy more and live their lives to the fullest. But when things are not very good, then consumers become conservative. In other words, there have to make decisions about what to buy and what not to be. But care must be taken when defining this term so that it should not be confused with the market cycle. The latter is measures regarding broad market indices, and it only affects the markets. Another term that usually confuses many is the debt cycle, which is the fluctuations in household and government debt.
When identifying sector winners and, or potential losers, economists use different investment approaches. In any case, they may use indicators like momentum approaches, top-down strategies on selected macroeconomic indices, or bottom-up methods to understand sectors that are improving. Many cases, however, it is a business cycle analysis that is used to determine these parameters. And because the business cycle shows characteristics that directly affect sectors or industries in a different way, investors may want to look at the sectors that are taking in the current economic situation better. It is all about identifying opportunities when things are low and high for maximum benefit.
In a standalone business cycle that follows sector rotation, investors find it hard to implement since there is an existing difference in economic conditions affection individual processes within a period, echoed innovations and technologies that continually impact business models and financial input. There is a good reason one should understand business cycle dependency on sectors, which improves the creation of sector portfolios, more-so in the top-down approach. This means sectors need to be fully aware of what is happening around them so that they can make proper adjustments in time, and do whatever they need, to avoid market failures.
When analyzing business cycles, especially within sectors, it is crucial to make a quantitative and systematic assessment looking at the performance of a specific sector/s over economic cycles. And for this, business analysts will need specific tools that let them make specific judgments, one which includes the Conference Board Leading Economic Indicator Index (LEI). This indicator helps to segregate business cycles and evaluated sector performance over many processes within a selected period, which can give a good sample size to understand performance in industry performance and persistency ins different rise-falls.
The main aim of business cycle analysis is understanding how specific businesses survived in different market failures and rises. It is important for investors to understand sectors that have the capacity to stand on their own without much interruption from external forces like government interventions and such.
Understanding the business cycle
It is not just enough to define a business cycle; understanding the concept could be key to forming a stronger method of dealing with economic recessions, and for future entrepreneurs, it all about having the knowledge to deal with these events, that always and must happen. Wesley C Mitchell and Arthur F Burns were the first people to introduce the idea of business cycles. The used took the indicator methods which employ the use of cyclical indicators to define patterns of economic changes.
Mitchell and Burns state, "Business cycles are a type of fluctuations found in the aggregate economic activity of nations, and that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same times in many economic activities, followed by similar general recessions, contractions, and revivals which emerge into the expansion cycle of the next cycle."
Based on this definition, we can say economic cycles are general effects on multiple sectors happening at the same time. A good example is the big economic recession than resulted from financial depression in 2007/2008. The housing industry was said to be the root cause of the recession as it boomed with a bubble, and lenders got excited, lending without much consideration of the borrowers' ability to repay. So, when the assets significantly dropped in value, they had no way of getting back their investment, which led to huge failures.
The Conference Board's LEI Index, first published in 1960 in by the US Department of Commerce, as a section of the Business Cycle Indicators program, employs the method above by putting into account ten economic indicators. It uses a range of tools ranging from employment, business order, and financial conditions, all the way down to consumer expectations. This approach helps summarize common turning point patterns in business information. The indicators also include the composite index, which withstood the test of various statistical and economic tests, economic significance, and statistical adequacy, among others.
In most cases, economists research on business cycles only on the basis of recession and expansion, going through peak and trough. Note, however, that there is so much more in the stages of an economic cycle between the peak and the trough.
There is, for instance, recession, which indicates the decline to a trough in a constant acceleration pace. Recessions don't just happen at once, it is like down at a steep slope, all the way from the peak, and they happen faster than expansion. After the rough, the business cycle starts rebounding in a process called recovery. This is a long-term trend that happens slower than recessions. From recovery, the next stage of expansion, which is positive changes in the economy, which goes above long-term trends. There is also the slowdown, whereby the changes go beyond the peak and starts to moderate. In this case, expansion is not happening as first, and it did in the beginning, and the next stage will be a recession.
Industry performance evaluation
Today, many market participants have recognized and are using the Global Industry Classification Standards (GICS) sector classification to identify how specific industries perform in various conditions. However, it is vital to highlight that its history is limited as it only dates back to 1989, and covers only three recessions. This is perhaps the reason it may not be of much help for those seeking a deeper understanding of what happens in the markets. It is critical to get the data from multiple sources and over a longer period, so than the comparison becomes more reliable. It is all about finding substantial evidence in more cases than just what may be seen as the obvious. In the case, there are other sources that analysis can also follow to get this data one such resource is the performance data of Kenneth French 48 SIC-based (Standard Industry Classification) data. This information contains industry portfolios dating as back as 1961, which can then be mapped with the latest data from GICS, especially on sector definitions. By weighing industry performance over this period, it is much easier to create a long history covering more recessions, recoveries, and slowdowns. Such information is vital not only to economists but also to those who want to invest in different sectors. It helps them understand what to expect at what time, what to do when it happens. As it is, there will always be downward trends as well as upward ones in the economy, and a proper analysis of the past times can help prepare for the future.
When analyzing sector performance, over a specified business sector, many researchers look at how the industry performed and how consistent the performance was in every cycle. Some of the metrics they use include average returns of the sector per month, average excess returns over the wider market, average return through individual processes, average excess return over each cycle, months percentage of when the sector performed better than the broader market, percentage of cycles when the sector performed higher and many others. This can then be calculated with the sector z-scores to determine standard results over all sectors, making it easy to compare. It is important also to weight each metric in order to the best and the least sectors in the business cycle, in any of the four main stages:
During this period, economic activities fall rapidly in the entire economy. There is a significant decline in economic outputs and aggregate demand both from consumers and businesses. This period is characterized by increase unemployment, higher uncertainty in consumers, as well as contractionary domestic production. Of course, governments will come up with monetary policies attempting to slow down or reverse the process. There are lowered interest rates and a surge in the money supply.
A recession can only go as low as the trough, where stops and the reverse begin. Economic recovery is initiated whereby things start rebounding sharply from the bottom, picking an upward trend. There is a visible increase in GDP growth and the acceleration of aggregate demand. Consumer's confidence in economic growth is restored as the start taking advantage of low-interest rates.
At this point, the economic cycle hits its peak, where rosy prospects and increasing prospects lure firms to allocate more funds in business expansion. Amid the rising demand, monetary policies come in it to increase interest rates and control the borrowing trends.
Just like the term suggests, utilization has reached the cycle peaks, and economic gaps change to positive. In this case, the economy is running beyond its expected limit, where its limited capacity constraints any further acceleration, which results in the economy achieve positive but decelerating growth. Monetary policies become stricter to avoid economic overheating.
Each of these stages comes with different needs for the consumers and the producers alike. When the economy is booming, everyone becomes free to take advantage of the available resources amidst technological advancement. When deceleration begins, and input costs increase, corporate profitability faces more pressure; hence it will remain positive but slower. Based on capacity and efficiency constraints, firms may choose to spend more on capital expenditure in reaction to expanding demand. Still, there is always less enthusiasm in Capex deployment and rising production. This is the time when investors take more defensive as the overall market starts turning to the worst. Since they are reducing their allocation to the economically sensitive sectors, Health Care and Consumer Staples will perform outperformance as Consumer Discretionary and Real Estate Industrial underperform.
The most anticipate performers during any stage of economic cycles are materials and energy. They come under certain expectations during slowdowns, as well as positive inputs, whereby they determine prices of oil and basic needs.
In the US economy, the energy did have never feature in either the top three or bottom three sectors during any cycle, which shows it may not be susceptible in its economic cycles. Still, it is in many other parts of the world. When oil prices go up, energy companies stand to gain more profits. Based on the fungibility of the industry and how it is connected to the global commodity market, worldwide demand-supply trends affect how these firms profit.
In the 1990s, there was a wide emergence of state-controlled chemicals and mining companies in developing nations, which great effected producers and miners from the US market, taking away from the great market shares and pricing power. So, the demand for materials may still be high at a certain stage, but the prices may not be as high. In other words, demand and supply for materials have a significant impact on business cycle analysis.
Business cycles are not something anyone can avoid. But if firms and individuals understand what causes them and how to live through, they would not feel its impacts. Knowledge makes everything seem much simpler.
Author: James Hamilton