Logical Economics and the Business Cycle
Logical economics sounds like a course we avoided in school or at least slept through. However, The intent of L.E and the business cycle is to try and take a look at what's going on with the economy and explain it in plain English, while looking at everything from the simplest point of view.
The business cycle has been around almost as long as business itself. Even the industrial revolution and the internet and technology boom have not shielded us form the ups and downs of the business cycle. Sure, they have made the ups longer and the downs shorter (maybe), but the presence of the cycle still exists today as it did centuries ago.
Expansion, peak, contraction, trough, or, bull market, top, bear market, bottom. These are the stages of business that make up the business or economic cycles we experience over time.
Now with the premise that the cycles exist, let's identify each cycle and try to explain their characteristics and describe investment opportunities presented
during each cycle.
The expansion stage of the economic cycle usually lasts the longest and produces the greatest amount of wealth. Unemployment is low as companies hire aggressively, trying to keep up with the increased demand. With demand strong, the marginal cost of hiring a new worker is offset by the increase in output and revenue generated by the new worker. Stock prices usually rally during the expansion, as corporate profits increase and sales and revenue grow exponentially. Interest rates and inflation both remain low, while consumer spending is growing during this stage of the cycle. Generally, real estate appreciates because of increased demand as well as low interest rates and positive inflation scenario. In short, this is the "life is good" phase of the economy.
The peak stage of the cycle is characteristic of euphoria. Stock prices appreciate radically. Consumer-spending surges. Rampant consumption on big-ticket items is evident. Stock price-to-earnings (P/E) ratios increase. Companies start to overbuild, overbuy, and over-hire as they feel the increase demand will never end. In short, this is the "eat, drink, and be merry" phase of the economy. Lately, this stage has lasted longer than in the past due to just-in-time inventories, greater technology advancements that allow businesses to manage their inventories, and a more sophisticated consumer.
The contraction stage is the most painful and unpleasant stage, but a very necessary one. During this stage, the economy might slip into recession, or at least into slowdown. Unemployment ticks up, and stock prices generally depreciate. Overall growth and investment slows. Wealth deteriorates as capital cannot be employed efficiently enough to produce return. Labor costs increase at first, as companies are producing less with worker productivity shrinking. Consumer spending generally slows, as does investment. Eventually, we see large layoffs, declining stock markets, and a tightening of credit that is extended to borrowers. In short, this is the "repentant" phase.
Eventually, this leads to the trough stage. During the trough stage a lot goes on, some of it unnoticed. On the noticeable side of things, companies layoff employees in large numbers. Stocks decline at a rapid pace. High unemployment leads to a drop off in consumer spending, and GDP is clearly negative. At this point, the Fed continues to lower rates and stimulate the economy with monetary policy tools. As part of fiscal policy stimulus, tax breaks and incentives for companies to invest and consumers to spend are put into place. With both monetary and fiscal stimulus in place, something happens in the middle of the trough cycle, which may not be noticeable at first. Companies, leaner and hungrier, eventually start to make money. With the labor force trimmed so lean, interest rates so low, and the government providing either tax breaks or incentives, companies have a good environment to make a profit. Additionally, labor costs are low and worker productivity per worker is extremely high. In short this is the "12-step program is working" phase and the economy is getting healthy again.
>From the trough onward, the stock market begins to recover and the tracks are being laid for the recovery and expansion stage of the cycle. When companies start to show profits and then eventually spend these profits on R&D, new plants and facilities, and then on more efficient production processes, guess what happens next? They begin hiring new employees, who spend their paychecks, and voila! Stock prices increase. This new wealth in stocks and salaries creates a wealth effect. Consumer spending increases, and the whole cycle starts over again.
With this knowledge it was quite obvious that we have been in an expansion phase for most of the latter part of the 90's. And with the help of hindsight, we clearly were in a peak during 1999 and 2000. That being said, the contraction we are experiencing now probably started at the end of 2000 or beginning of 2001.
Breaking the economy into logical pieces and over-simplifying things for argument's sake, capital or money invests in labor to produce an output. The capital hopes to achieve a return from its investment by employing the labor to make or produce goods and services that can be sold for a profit. If all is going well, then businesses will invest more in labor by hiring more workers to make more goods, to sell more products, and make more money.