“Over long stretches, the economy grows thanks to rising population and productivity. But in the short run, it goes through cycles of expansion and recession. Catching the bottom of the cycle can turbocharge your portfolio or business plan, while missing the peak can lay waste to both.” -Greg Ip
In the second chapter of "The Little Book of Economics: How the Economy Works in the Real World," Greg Ip took on an issue critical to many value investors: business cycles, recessions and depressions. Or, as Warren Buffett (Trades, Portfolio) might say of the latter two, “good times,” as in a good time to go hunting for stock market bargains.
Ip argued that business cycles and market cycles have important similarities. They are both triggered by the tug-of-war between expectations and reality. Further, business cycles and market cycles are mutually reinforcing.
When companies report rising profits, investors expect more of the same in coming years and bid up their stock prices. And the rise in stock prices leads to business expansion, fueled by easy credit.
As we all know, such activity sometimes produces bubbles, or a bubble-like enthusiasm, followed by a dramatic downturn, even corrections and crashes. Ip pointed out that bear markets often fall more violently than bull markets rise. In hindsight, we can usually pin a recession to a specific cause, but looking ahead is different. Ip wrote:
“We sometimes think we’ll eliminate recessions if we could just inoculate ourselves against past imbalances. After all, we can develop immunity to the last virus we contracted. The problem is that it mutates and we’re susceptible all over again. The same holds true for the business cycle. Every business expansion eventually dies. Only the cause of death changes.”
Does the Federal Reserve cause recessions? Ip quoted economist Rudi Dornbusch as saying (in 1998), “None of the post-war expansions died of natural causes, they were all murdered by the Fed.”
Whether the Fed is that responsible (irresponsible?) may be a matter for debate, but there is no question its actions directly affect the economic world. When it thinks the economy is growing fast enough to push up inflation, it raises the interest rate and the cost of borrowing, forcing both businesses and consumers to cut back on their spending. This tranquilizer should slow the growth of inflation.
It can also do the opposite. By reducing interest rates, it can give the economy a shot of caffeine. Cheaper credit, for both businesses and people, leads to new business expansion and consumer spending; all that leads to economic growth and, for a time at least, creates a virtuous circle.
Ip added that business cycles changed after 1982, when inflation was brought under control, so that the Fed did not have to change interest rates as much or as often. At the same time, innovation and deregulation helped banks overcome Regulation Q (which capped limits on how much banks could pay on deposits), while just-in-time management kept inventories in line with sales.
While moderation is now more common, busts still occur as we saw in the dot-com and subprime crises. Ip wrote that depressions (roughly defined as severe recessions) occur “when the economy’s normal recuperative mechanism fails to engage.” He usesd a bungee cord as an analogy for the ups and downs of economic cycles; normally, the cord stretches one way and then the other, but sometimes the bungee cord breaks. More technically, this happens when lower interest rates fail to kickstart demand and the virtuous circle cannot get going again.
During a depression, a structural problem also occurs: Assets acquired during a boom will collapse in value, but debt does not because it must still be repaid. For example, that happened after the prices of Japanese stocks and land collapsed in the early 1990s. Many businesses and consumers were paying down their debts, and thus could not borrow and restimulate the economy. Similarly, three years after the subprime crisis, almost a quarter of American homeowners carried mortgages greater than the value of their homes.
What’s more, a frail economy recovering from a crisis is also more susceptible to further ills, such as a spike in oil prices. Great Britain had recovered somewhat after the subprime crisis, but fell back into recession in 2011 because of economic turmoil in Europe.
In this chapter, Ip has laid out an easy-to-follow overview of business and market cycles, explaining the drivers behind growing and receding economies.
Cycles and investing for new investors
In the investing world, we refer to the growth phase as a bull market and the receding phase as a bear market. Of course, the stock market, or any individual stock, does not go straight up or straight down. Instead, it rallies and corrects many times before hitting a peak or trough.
Value investors, at least those with cash available, like to get started in the trough, when stocks are cheap. Not just cheap, but cheap because the whole market has fallen despite continuing strength in the fundamentals of quality companies.
Similarly, value investors who hold for the medium to long term will see at least some of their stocks become overvalued after a bull market has dominated for a certain amount of time. With that overvaluation come opportunities to sell and harvest hearty capital gains.
So the theoretical cycle for value investors is to buy near the bottom of a bear market, when prices are undervalued, hold and then sell them near the top of a bull market. Such thinking implies market timing, and the perils it adds to investment success.
To protect themselves from timing errors, many value investors do enough research to identify the intrinsic value of a stock and then buy when the share price drops a certain percentage below that intrinsic value.
On the upward side, the targets are less quantitative or objective. Some investors are willing to get out relatively early and take profits, rather than staying in a risky position. Others are willing to hold on and hold on, betting that they can get out at the last minute and “not leave any profits on the table.” Yet others will stay with some of their stocks through bear and bull markets alike, expecting to enjoy the compounding of annual growth. These strategies are generalizations; in real life, there are an infinite number of possibilities, including the strategy of having no strategy at all.
Summing up, in chapter two of "The Little Book of Economics: How the Economy Works in the Real World," author Ip has shown how economic and business cycles are fueled and how the Fed attempts to keep the economy and inflation on a relatively even keel with interest rates. And, I have added a section that explains how value investing in general seeks to harness the cycles for capital gains.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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