Principles of the Master Cyclist

“The brightest people in the world didn’t see [the recession] coming.” JOHN CHAMBERS, CEO, CISCO SYSTEMS INC.

“It was obvious the booming economic cycle couldn’t continue. We tightened our belts. We focused on cash flow.” RALP H LARSEN, CEO, JOHNSON & JOHNSON

As these two sharply contrasting views of the 2001 recession suggest, some managers seek to manage the business cycle proactively, while others deem it a pointless exercise. There is a similar divergence of opinion within academia. Many professors of both economics and finance believe that, like the stock market, the business cycle is a “random walk” that can’t be predicted — and therefore can’t be managed. Others believe that managers who carefully cultivate financial market literacy, who studiously follow leading economic indicators and who draw upon various forecasting models are likely to manage their companies better than their peers. I belong to that contrarian minority.

Prior to the 1980s, most economists viewed the business cycle as largely unsystematic and unpredictable. Since the 1980s, however, there have been numerous studies validating the predictive value of a number of leading economic indicators, including stock prices, the so-called “yield curve” and the Conference Board’s Composite Index of Leading Economic Indicators (an index that reflects both the yield curve and stock prices as well as eight other indicators).

Despite the existence of these studies, many academics still reject their findings and doggedly cling to the notion of a random walk business cycle. In this regard, stock prices remain a favorite butt of an almost 50-year-old quip from Nobel laureate Paul Samuelson that “the stock market has predicted nine of the last five recessions.” Nonetheless, at least some studies have found that stock prices have some predictive value, particularly when used in conjunction with the yield curve.

The yield curve — which measures the spread between short- and long-run Treasury securities — is perhaps most interesting from a managerial perspective. At any given point in time, the shape of the curve can be normal, flat, inverted or steep. An inverted yield curve has been historically quite accurate in predicting recessions, while the steep yield curve has been only slightly less accurate in predicting expansions.

The Index of Leading Indicators has been found to be at least somewhat useful in predicting movements in the business cycle.