book.chapter Business cycle constituents

Before the onset of the most recent recession, which was precipitated by turmoil in the financial markets, there existed a somewhat complacent belief among some analysts and commentators that the intricacies of the business cycle had been so thoroughly deciphered and understood that it would no longer exert a significant influence on market dynamics. However, the subsequent unfolding of events has starkly illuminated the erroneous nature of such assumptions. In contemplating the future from an investment standpoint, it becomes imperative to incorporate considerations of the business cycle into one's analysis. The overarching business cycle is invariably shaped by the interplay of three distinct cycles: inventories, capital spending, and property. Inventories, which account for approximately 6% of the Gross Domestic Product (GDP), typically undergo a cycle every four to five years. Capital spending, representing around 9-10% of GDP in most nations and slightly higher in rapidly growing emerging markets, experiences a downturn approximately every nine to ten years. The property sector, known for its inherent volatility, sees most countries allocating 9% of GDP to residential property and an additional 3% to commercial property, with expenditures evenly split between improvements and new construction. This sector faces a downturn every eighteen to twenty years. A phenomenon known as "modelocking" often occurs, whereby a downturn in one of these cycles precipitates a concurrent downturn in the others, underscoring the interconnectedness of the economy's various sectors. Despite some economists' belief that the business cycle's impact has been neutralized through better understanding, it is crucial to recognize that the business cycle is deeply rooted in human psychology and driven by specific causes and effects that will persist indefinitely. Thus, over the next forty years, spanning from 2010 to 2050, it is reasonable to anticipate at least eight to ten inventory cycles, three to five complete cycles of capital spending, and a minimum of one, but likely three, property cycles that could precipitate banking crises. From this perspective, the global financial market meltdown that occurred between 2007 and 2009 was, in fact, quite predictable. The property market in several countries had reached unsustainable levels, necessitating a natural, cyclical correction. Concurrently, it was revealed that the financial system had extended excessive credit during the preceding years of market ascension. This led to a situation where individuals who were over-leveraged began defaulting on their loans, resulting in the evaporation of trillions in paper profits. The ensuing reluctance among banks to lend to one another precipitated a stock market crash as working capital dried up. The ripple effects were felt across the economy, leading to layoffs, reduced inventories, and a general contraction in economic activity. However, it is important to remember that crises are transient, much like the booms that precede them eventually lose momentum and reverse. Historical precedents, such as the recovery following the Great Depression of the 1930s and Japan's economic crisis in the 1990s, demonstrate that markets tend to rebound strongly after significant downturns. Thus, the years ahead are likely to be characterized by a series of financial bubbles, scares, and crashes. Financial bubbles will emerge whenever a particular group of assets experiences a rapid and unsustainable increase in prices. Given that there have been at least 47 such bubbles since 1557, and considering the volatility of modern markets, it is plausible to expect at least one bubble followed by a crash every three years on average over the next four decades. Similarly, market scares, often amplified by media coverage, will continue to occur with regularity. These scares, which can range from health crises to technological fears, represent a form of collective anxiety that can have tangible financial impacts. To navigate the investment landscape successfully over the coming forty years, it is crucial to distinguish between phenomena that are part of the business cycle, those that constitute bubbles, those that are mere scares, and those that represent underlying trends. By aligning investment strategies with the general direction of these trends, while avoiding the distractions posed by bubbles, scares, and the cyclical nature of the business cycle, investors can position themselves for success. In conclusion, the path of human civilization, and by extension the global economy, has never been linear or smooth. The future will undoubtedly be punctuated by unpredictable events as well as recurring phenomena that have a significant impact on financial markets. Distinguishing between these various phenomena, while challenging, is essential for developing a comprehensive understanding of the economic landscape and making informed investment decisions.