Understanding Where We Are in the Business Cycle — and Why It Matters to Investors– February 03, 2015

Whether you are focused on “top-down” investing (starting with big picture perspectives and working your way down to individual investments) or a “bottom-up” approach (focusing on the inherent merits of an investment first), knowing where you are in the business cycle is critical. It is probably more important in a top-down approach to making investment decisions.

Many have a basic understanding of boom/bust business cycles. Every economy has a long-term growth trend line, and business cycles in the form of fluctuations according to economic activity (measured broadly as GDP, Gross Domestic Product) revolve around this trend line. This graphic shows the full cycle of trough / expansion / peak / contraction very well:

Graph Source: RDC Econ 101 Wiki

Ray Dalio — the giant brain that runs Bridgewater, the largest hedge fund company in the world— is considered one of the smartest investors and wrote one of the best non-academic explanations of the business cycle in his piece How the Economic Machine Works. It is a definitive must-read if you enjoy studying the market. Below is his helpful and concise summary of how the business cycle works:

A short-term cycle, (which is commonly called the business cycle), arises from a) the rate of growth in spending (i.e. total $ funded by the rates of growth in money and credit) being faster than the rate of growth in the capacity to produce leading to price increases until b) the rate of growth in spending is curtailed by tight money and credit, at which time a recession occurs.

In other words, a recession is an economic contraction that is due to a contraction in private sector debt growth arising from tight central bank policy (usually to fight inflation), which ends when the central bank eases.

Recessions end when central banks lower interest rates to stimulate demand for goods and services and the credit growth that finances these purchases, because lower interest rates 1) reduce debt service costs; 2) lower monthly payments (defacto, the costs) of items bought on credit, which stimulates the demand for them; and 3) raise the prices of income-producing assets like stocks, bonds and real estate through the present value effect of discounting their expected cash flows at the lower interest rates, producing a “wealth effect” on spending.

Since valuation is a subjective science (or an art, perhaps) for “income-producing assets like stocks, bonds and real estate” mentioned above, it helps to know where we are in the business cycle for top-down investing. More specifically, knowing where we are today in this expansion phase and how far away from the next peak.

As you might imagine, it is hard to arrive at a definitive answer.

All of the key forward indicators we review remain consistent with continued strength employment and GDP growth, along with an upbeat view of 2015. The most important of these forward indicators is the slope of the Treasury bond yield curve, which has been an extremely accurate predictor of future economic direction in the business cycle. The normal trajectory of the yield curve is upwardly sloping (shown below). Depending on happenings in the economy, the slope can be steeper than normal, less steep than normal, flat, and, very rarely, inverted (e.g., short-term rates are higher than longer-term rates).

Graph Source: Sequoia Financial Advisors

There are many explanations as to why the yield curve is sloped any one way at a particular moment. In very basic terms, it varies with the supply and demand of time-sensitive, investable money. If more people than not believe they have nothing better to do with their money for the next 10 years than locking it up in risk-free Treasury bonds, 10-year interest rates will be lower, everything else being equal. If these same people see better opportunities for their money and are willing to take more of a risk, they will sell bonds and do things that offer a better return such as buy stocks or invest in income-producing projects. This simplified concept can be applied to all time frames on the yield curve and, therefore, the slope is determined according to supply and demand.

The slope of the yield curve ended 2013 at one of the steepest on record. While the curve spent most of 2014 flattening, it is still relatively steep compared to history when looking at the difference between the two-year and 30-year yields or the three-month and 10-year variant.

A steep yield curve is normally associated with an economy that is expected to grow faster than the current trend growth in the future. An inverted yield curve is associated with an economy about to go into recession. The graphic below compares the inverted yield curve in 2007, which predicted the “Great Recession,” with the much steeper upwardly sloping yield curve we have today:

Graph Source: U.S. Department of Treasury

It is a near certainty that the steep yield curve will flatten and the business cycle will peak in the future. It is just a question of when. MKM Partners Chief Economist & Market Strategist Mike Darda points out that the combination of tightening labor markets and tightening interest rate policy from the Federal Reserve Bank has been associated with a flattening yield curve and predated every major business cycle peak in post-war history! He also has a number of important related observations:

  • Together, tightening labor markets and tightening interest rate policy are nine for nine in the last nine business cycle downturns and tend to lead cycle peaks by 10 months.
  • Out of 19 recessions in the century since the inception of the Fed, there is only one (1945) that was not in some way associated with direct monetary tightening.
  • Aside from the 1930s and 1981, every downturn over the last century came after the output gap went positive and unemployment fell to below average levels.

While most market participants expect the Fed to commence raising interesting rates in the coming year, the output gap is still negative, labor market slack is still on the high side and inflation remains low. Therefore, we believe this can be a longer-than-average business cycle expansion.

The yield curve is a very powerful economic indicator and one of the best tools we have to help us understand where we are in the business cycle. While we cannot predict the future, we study the yield curve closely looking for important inflection points to help us properly construct portfolio asset allocation for the future economic environment … and according to the yield curve, the future looks pretty good!

We want to hear from you! We encourage you to comment below on this blog post, share it on social media or contact Russell Moenich at rmoenich@sequoia-financial.com for further discussion. You can also visit www.sequoia-financial.com.

The views and opinions expressed in this article do not necessarily reflect those of Cohen & Company.

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