The Business Cycle and Its Indicators

The cycle

Four phases: expansion, peak, contraction, trough — and then expansion again.

Expansion brings rising output, rising employment, rising corporate profits, and eventually rising inflation. Contraction, sometimes called recession, brings the opposite.

A recession is conventionally defined as two consecutive quarters of declining gross domestic product. A depression is a prolonged and severe contraction, conventionally six or more consecutive quarters of decline.

Gross domestic product is the total value of goods and services produced within a country. Gross national product measures production by a country's residents wherever it occurs. The difference is geography versus ownership.

Inflation is a general rise in prices, measured principally by the Consumer Price Index. Deflation is a general fall, and it is more damaging than it sounds because it raises the real value of debt and encourages spending to be deferred. Stagflation is the combination of stagnant growth and high inflation, which is difficult because the policy responses to each work against the other.

The indicators

Indicators are classified by whether they move before, with, or after the economy.

Leading indicators move first, and are therefore what forecasters watch: building permits, new orders for durable goods, stock prices, the money supply, initial claims for unemployment insurance, manufacturers' new orders for consumer goods, and consumer expectations.

Coincident indicators move with the economy: industrial production, personal income, manufacturing and trade sales, and non-farm payroll employment.

Lagging indicators confirm afterwards: the average duration of unemployment, corporate profits, the prime rate, the ratio of inventories to sales, commercial and industrial loans outstanding, and the change in labour cost per unit of output.

The two that catch candidates: stock prices are a leading indicator, and the prime rate is a lagging one. Both feel like they should be the other way round.

Sectors, and the international measures

Cyclical industries move with the economy and amplify it: automobiles, construction, heavy machinery, steel, luxury goods, durable goods, travel. They lead an expansion and fall hardest in a contraction.

Defensive industries hold up through a contraction because demand for what they sell is inelastic: food, utilities, pharmaceuticals, basic household goods, tobacco and alcohol. A customer worried about a recession is pointed here.

Growth companies reinvest earnings rather than paying them out, are valued on distant future earnings, and are therefore hurt more by rising rates than value companies are. Value companies trade at low multiples relative to their fundamentals and often pay dividends.

Counter-cyclical industries actually do better in a downturn — discount retail and some repair services are the usual examples.

Internationally: the balance of payments records all transactions between a country and the rest of the world, with the current account covering trade in goods and services and the capital account covering financial flows. A trade deficit means imports exceed exports.

Exchange rates determine what a currency buys. A weaker dollar makes US goods cheaper abroad, so US exporters gain and US importers lose; a stronger dollar reverses it. American Depositary Receipts carry currency risk for exactly this reason: the underlying shares are priced in a foreign currency.

Financial statements

Two statements, and the SIE tests their purpose rather than their ratios.

The balance sheet is a snapshot at a moment in time. Assets equal liabilities plus shareholders' equity. It shows what the company owns, what it owes, and what is left for the owners.

The income statement covers a period. It reports revenue, the costs of producing it, and what remains as profit — moving from revenue through operating income to earnings before taxes to net income, and then to earnings per share.

A third statement, the statement of cash flows, reconciles reported profit to cash actually generated, which matters because depreciation and amortization reduce profit without consuming cash.

The two measures worth knowing by name: earnings per share is net income available to common shareholders divided by shares outstanding, and the price-earnings ratio is the market price divided by earnings per share. The Series 7 course develops the full set of ratios; for the SIE, knowing what each statement is for is the requirement.