Overview:
- The economy expands and contracts and those fluctuations are measured in business cycles;
- The GFC is an example of a very sharp business cycle;
- Bull and bear markets reflect investor confidence;
- Fiscal and monetary policy are tools to manage the business cycle.
While business cycles are easy to understand conceptually, predicting them is near impossible.
Even the best economists struggle.
What is the business cycle?
A business cycle traverses the rise and fall of gross domestic product (GDP).
As the economy expands and contracts, we can see patterns emerge over time and those fluctuations are measured in "business cycles".
There are four stages: expansion, peak, contraction (or recession) and trough.
GDP is a way to measure the economic output of a country by finding the total value of everything that country produces.
The length of a business cycle is defined by the time between a single boom and bust.
A boom is a period of growth in the economy; where business are icreasing their output, people are buying things, prices of everyday goods and services are rising, the majority of people have work and share prices are lifting.
A bust is where all of that stuff is happening the other way: businesses aren't selling as much so they tighten production, people are reluctant to buy things, prices of everyday goods are falling, people are looking for work and share prices are falling.
The idea of a business cycle came from Jean Charles Léonard de Sismondi’s 1819 book, Nouveaux principes d’économie politique.
Prior to this, classic economists denied the existence of business cycles. They thought wars, famine and other episodic catastrophes caused prices to rise and fall.
Léonard de Sismondi suggested that instead of markets finding equilibrium through direct events, they instead move through periods of natural "crisis".
As such, mass human economic bahviour could prompt a downturn, even in peacetime.
Chances are if you’re reading this, you can remember the Global Financial Crisis (GFC) in 2009. The global economy seemed like it was unstoppable (until it wasn’t).
At the time, share markets were rising and consumers were spending freely. Then the housing market collapsed which slammed the breaks on the US economy.
That the economy slowed down so much so quickly, prompted a sharp shift in the business cycle.
Companies like Lehman Brothers collapsed, currency prices fell and millions of people lost their jobs.
One company does not equal a business cycle
Business cycles track the economy as a whole. Rarely does a single industry cause the entire market to collapse.
That said, it's probably important to note the GFC was a unique circumstance where the collapse of one industry (housing) triggered a domino effect across the entire economy.
House prices, which had been soaring higher and higher, were largely propped up by Wall Street instruments called mortgage-backed securities (MBS) and collateralised debt obligations (CDO).
These instruments allowed bankers to buy packages of mortgages with varying degrees of risk.
These different levels of risk are referred to as “tranches”. Both MBSs and CDOs offered attractive rates of return due to the higher interest rates on the mortgages.
The problem was that banks had incredibly lax lending policies, meaning people who really could never afford to maintain their mortgage payments were given loans.
But when house prices began to fall and it became clear that many people couldn't afford their repayments, there were widespread defaults.
Defaulting just means people don’t pay back their loans. And Wall Street was very exposed to the housing market (through the MBS and CDOs) that they took heavy losses too.
If you’ve read The Big Short, you get the idea. If you haven’t, it’s a good read.
The key thing to understand as a potential investor is business cycles happen. And the GFC is an example of a very fast, very dramatic and painful business cycle turn.
And if history is to repeat itself, it’s not a question of if, but when a cycle will bottom out.
A bull market
Investor expectations play a big role in the business cycle: they can shorten or drag out where we are.
If you’ve ever heard someone say we’re in a bull or bear market, that’s what they’re talking about.
When we’re in a bull market people feel positive about the overall economic environment. It can even lead to people who don’t invest to start investing and generally more buying activity.
This can lead to further price inflation.
The bear market
Conversely, bear markets happen when investor confidence is down.
If people think a downturn is coming, investors may pull their money out of the market fearing that they’ll lose it.
This causes other investors to pull their money out and as money leaves the market stock prices can begin to fall. This can cause more people to pull out and so on.
That said, bear markets aren’t innately bad. As stock prices decline, some investors choose to buy stocks. As Warren Buffett said:
“Be fearful when others are greedy and greedy when others are fearful.”
Fortunes are made and lost during bear markets.
Timing the market
Whether timing the market is a viable investment strategy is controversial.
Some people think it’s impossible to know when a business cycle is at its start or its end. Ideally, you'd like to buy in just before the expansion phase and sell just before the contraction phase.
Who manages the business cycle?
The government has a few tools to manage the business cycle; namely fiscal policy.
That's how much the government is spending and how much tax they are charging.
When a government wants the economy to expand they generally should spend money themselves or prompt other industries to do the same, via tax cuts.
When an economy is growing too fast and prices are rising too quickly, they generally should us contractionary techniques. This means they should raise taxes and cut government spending.
But governments rarely do this because chances are they will get voted out of office.
The central bank uses monetary policy to control the business cycle. This means raising and lowering interest rates (how much it costs to borrow money).
When the central bank wants to boost the economy and end a contraction or a trough, they lower interest rates. When rates are low, businesses and people can borrow money cheaply and this prompts them to get busy and build their businesses!
Then the economy is zooming along, the central bank can raise interest rates and keep a lid on just how quickly things are growing. They do this to slow down the approach to a peak.
The goal of fiscal and monetary policy is to keep the economy growing at a sustainable rate. It should be strong enough to create jobs for everyone who wants one but slow enough to avoid inflation.
Summary
A business cycle is the pattern of growth and contraction.
A common way to track business cycles is by using GDP and unemployment. GDP rises and unemployment shrinks during growth phases, while reversing during contractions.
Even though we call them cycles, the fluctuations do not occur in a uniform pattern and are almost impossible to predict.
But it's handy to have an idea where we are in the cycle.
