by Dr. Stanley Riggs
Economic cycles were first recorded in 1349 in Florence, Italy. Sir Isaac Newton (as in “gravity”) lost his fortune when he failed to recognize the 1720 South Sea Company financial bubble. There have been over 300 asset bubbles since 1720. But you don’t need to be a genius to avoid getting caught up in an economic cycle. By always being aware of where you are in the economic cycle, you can both protect and grow your savings in the new year.
What are Economic Cycles?
Economic cycles, often referred to as “booms and busts,” are recurring macroeconomic events with high and low inflection points triggered by a change in macroeconomic, demographic or geopolitical events. The ever-changing cycles present both crisis and opportunity. It is a predictable model based on the theory of “reversion to the mean.”
Reversion to the mean is a concept that, when correctly applied to a cyclical situation, assumes that both the highs and the lows are only temporary, and values will always move back to the mean or average. A common mistake is to consider the values as reverting only back to the mean. In reality, the values revert back to the mean and continue to overshoot the mean before reaching their next high or low inflection point. It is the constant, symmetrical, bi-directional overshooting of the mean value that keeps the mean or average value relatively stable.
The Economic and Financial World is Dynamic and Non-linear
Another common mistake, even the best economists make, is to apply linear thought to nonlinear, cyclical events. When the stock market was booming in 1999, the linear thinkers were talking about the “new metrics” and when the waitresses at the local IHOP were making money flipping houses in 2007, the mortgage brokers were talking about the “new paradigm” as they extrapolated the cyclical upward curve to an endless, linear, climbing forecast. Even at the bottom of the Great Recession in March 2009, Wall Street bond fund sages coined the phrase “the new normal,” implying the economic recovery was forever going to be linear and almost horizontal. Linear thought only leads people to believe that the good times will never stop and the bad times will never end.
Hockey star Wayne Gretzky often said:
“I skated to where the puck was going, not to where it was.”
There are four reliable and readily accessible economic indicators that will help you to know where the economy is going. It is almost impossible to determine the actual inflection points (the top or bottom of the curves), but it is critical to have a clear understanding of which side of the curve you are on, which inflection point you are approaching and how much time you have left.
The ‘Big Four’
1. The Yield Curve is the most accurate indicator. It is the plotted range of yields of U.S. treasuries from short-term to long-term maturities. There is a strong correlation between this interest rate spread and the future U.S. GDP six to twelve months ahead. A steeply climbing curve illustrates long-term U.S. treasury rates significantly higher than short-term rates and is a forecast for economic growth. An inverted or downward curve illustrates long-term rates lower than short-term rates and indicates the probability of an economic downturn. Since 1960, all seven U.S. recessions have been preceded by inverted yield curves months in advance.
2. The Institute of Supply Management (ISM) is a private institute founded in 1915. They release to the public monthly reports on the recent trends of purchasing and supply management professionals.
3. The Composite Index of Leading Economic Indicators is data released by the U.S. Commerce Department. From 1959-2001 it correctly forecasted all seven recessions that did occur and five recessions that did not occur.
4. The Chicago Board Options Exchange Market Volatility Index (VIX) has been used since 1986 as a measure of the implied volatility of the Standard and Poor 500 Index based on options and future trades. If your financial advisor thinks the “VIX” is a brand of cough drops, you might have a problem.
Try to Skate to Where the Puck is Going
Changing economic events should never be a surprise to the student of economic cycles. Whether you are investing in stocks, bonds or real estate, you can benefit from these cyclical changes by using your understanding of the economic cycle as a cornerstone in your investment decision-making process in 2015. By always knowing where you are in the cycle, you can anticipate and benefit from future economic, cyclical changes and build your wealth by skating to where the puck is going.