Is the Economy in Uncharted Territory?
Last weeks entry “The Recession is Over- Stronger than Expected Recovery Underway” sparked quite a controversy among readers. I received numerous comments that disagreed with my positive economic outlook and some even called to question my sanity. Initially, I was surprised by the negative reactions, so I tried to understand the economy from their perspective. What I found was that the majority of people do not “feel” that the economy is improving. In fact, the average American is concerned with unemployment, housing and government expenditures and this leads them to believe this “Great Recession” is far from over.
I will take this opportunity to educate the readers on the Business Cycle as I believe many of you simply do not know the characteristics of the stages. With this knowledge you will have a better understanding of the economy and where it is headed.
So what is the Business Cycle?
The business cycle is the consistent fluctuations in the level of economic activity between growth and contraction. The typical business cycle lasts for approximately 4-5 years from peak to peak. Essentially the business cycle is a reflection of market psychology the alternation between caution, optimism, greed, and fear. With this in mind, there is no reason for the business cycle to not continue in the future unless there is a substantial change in human nature.
What are the stages of the Business Cycle?
1. Early Expansion
In this initial phase of the business cycle the production of goods and services start to increase rapidly. To further improve consumer confidence, interest rates are at low levels; in addition inflation rates are low and sometimes negative.
2. Late Expansion
As consumers finally begin to feel optimistic, the demand for goods and supplies increases dramatically. Interest rates also rise as consumers are more willing to borrow in order to purchase more goods.
3. Peak
When the economy reaches the peak, the economic growth rate begins to slow down. Consumers become greedy as they are now accustomed to the prosperous growth over the last expansion.
4. Early Contraction
Consumers begin to see the effects of the decrease in the economic growth rate. Consumer demand, corporate production, and employment rates all begin to decline. The economy is on its way towards a likely recession.
5. Late Contraction
The economic growth rate continues to contract at a faster rate. Once again consumer demand, corporate production, and employment fall as the recession is in full force. Consumers are now finally cautious about the future expectations of the economy.
6. Recovery
This is the final phase of the business cycle and the phase we are currently in today. The economy bottoms out and begins the healing process. Fear is rampant as consumers have cut back on all unneeded expenditures. Interest rates and mortgage rates have dropped substantially in order to restore consumer confidence. Unemployment peaks at the end of the recovery stage.
The current economy is by no means in unchartered territory. As noted above the economic environment today fits directly into the recovery stage of the idealized business cycle. Currently, we are at the culmination of the prior business cycle and on the verge of starting a new cycle.
Next week I will explain: leading, coincident, and lagging indicators and why people are not “feeling” the improving economy. As always, please feel free to voice your opinions in the comments section below. I hope you all have a Happy Halloween! -Jim
Jim,
Although I can appreciate your tutorial on “The Business Cycle”, not all business cycles are exactly the same and this one has been radically impacted by the most severe recession we have seen in a very long time followed by the most significant government stimulus/spending package we have ever seen in the history of this country. That is both in absolute and real dollar terms. This directed and immense government stimulus, massive liquidity injection and government takeover of certain critical sectors of the economy will result in a very different type of recovery. Most of these programs are now being followed by regulatory tightening and potential further socialization of a 2 trillion healthcare sector and further taxation in the form of Cap and trade. It is in these fine points that your readers are responding as it is their role to develop investment strategies for their clients. There are a number of economists out there given a view that certain indicators of recovery are in play but these growth indicators will have a different affect from previous cycles as other drivers at play now will mitigate a broad and robust recovery. I like the economists at the Conference Board, a New York based economic think tank. http://www.conference-board.org/pdf_free/economics/2009_10_14.pdf
I think an interesting topic for you to examine would the affect of massive federal deficits on the largest developed economy in the world and what strategies should we employee for our clients. Look forward to your analysis.
Jim,
In many ways the reason we are in uncharted territory is that the last expansion was push on by many factors, including low interest rates, to continue for two years past where it should have ended. The level of spending and transactions during those extra two years, especially in housing, lead to a contraction that is far larger than it needed to be if it had been let to contract at that time. And the way many people used their home an ATM rather than an investment means that they are poorer in cash flow for a long time.
It is also uncharted territory due to the fact that many of the people who are in the middle of this – unemployed, underemployed, underwater mortgages, tough financial conditions – have entered the workforce since the economy was in this shape, the mid-80s. They have not seen the cycle work through something of this magnitude.
Lastly, I think that the “Business Cycle” has fundamentally changed by the level and quantity of services as the delivered good in many transactions. I work in IT and Project Management and the work I deliver is not a hard good but just services. Much of my consumption is similarly service based and discretionary. The analysis of the business cycle in many ways is based upon the hard good economy not a purely service based, discretionary economy. Even in the hard goods that appear on the shelves, the level of inventory is kept at a low level all the time (cars being a big exception) rather than going through the boom and bust of past cycles.
You would be wiser to look at business cycles where the federal government took over large parts of the economy such as the 1930′s. Not a rosy scenario even for an economy that actually had a substantial manufacturing base.
Jim,
You obviously have seen the pop in GDP for this quarter and how it is being or not being received as it is broken down and analyzed. One of the most notable changes was the contribution from Motor Vehicle Output contributing 1.7% to the 3.5% growth number; thank you “cash for clunkers” (14.1 SAR August, 9.2 SAR September and estimated maybe 10 SAR for October). When this program strips-out in the 4th quarter, what will this number look like? As we move into the heating season in the US, the increase in the price of oil (from mid 40’s to now over $80 a barrel) could possibly help offset the negative effect of decline in Auto Sales but we shall see.
The bigger concern is the profit taking we are beginning to see and some early indication of softening in the credit markets. An early indicator is the Bank Loan Mutual funds and their NAV as this is a market that trades on private information under confidentially agreements with their large corporate borrowers. Their NAV reflects the direction of this information as either positive or negative. A very good indication of on the health of the large cap corporate market and their public data to come in one or two quarters .