What are the different types of business cycles in economics? How do these cycles influence a business’s success?
Howard Marks claims that three foundational cycles impact business prosperity (and consequently the value of securities): These are the economic cycle, the profit cycle, and the credit cycle.
Let’s examine these three cycles to illustrate their underlying causes and their impact on securities.
1. The Economic Cycle
The first type of business cycle in economics is actually called the economic cycle. According to Marks, the economy experiences cyclical swings as it expands and contracts. These swings lead to long-term economic fluctuations due to shifts in productivity and net hours worked, as well as short-term fluctuations due to changes in spending patterns.
Regarding long-term change, Marks points out that the gross domestic product (GDP)—the value of all goods and services produced per year—varies depending on the total hours worked and the productivity of those hours. He explains that consequently, the GDP undergoes long-term swings due to changes in birth rate, as a higher birth rate at one point in time will cause a spike in total hours worked several decades later. In the US, for example, although GDP increases on average 2-3% per year, it’s subject to long-term cycles that mirror cycles in birth rates.
Regarding short-term change, Marks notes that the economy can fluctuate sharply on a yearly basis even though it trends upward over time. He writes that these fluctuations occur because consumers’ spending habits are fickle—for example, if the government were to issue stimulus checks, that would temporarily cause a spike in spending that jolts the economy. By contrast, if political unrest in a region were to cause consumers to worry, they might be less likely to spend, causing a short-term economic slowdown.
2. The Profit Cycle
Marks relates that the economic cycle is closely related to another foundational cycle: the profit cycle. However, he explains that while the economic cycle’s fluctuations are rather small—GDP rarely increases more than 5% or decreases by more than 2% over a year—the profit cycle undergoes sharp swings as profits regularly increase far more than 5% or decrease far more than 2%.
Marks points out that these sharp swings happen for two reasons. First, many industries’ sales (which correlate with their profits) are extremely sensitive to shifts in the economic cycle. For example, the tourism industry sees exponential sales increases in years of economic prosperity and exponential decreases whenever there’s a recession. For this reason, their profits are much more volatile than the economy at large—if the GDP dropped 1%, for example, profits in the tourism industry might drop 10%.
Second, Marks explains that companies that are highly leveraged—that is, financed heavily with debt—have profits that are much more sensitive to changing sales revenue because they have to make interest payments that cut into their profits. For example, imagine a start-up company that’s financed with $50,000 of debt, requiring $5,000 annual interest payments, and $50,000 of equity. If this company’s operating profits (that is, its profits from sales before deducting interest payments) dropped from $15,000 to $7,500, then its true profits would drop from $10,000 to $2,500 after deducting interest payments. In other words, a 50% drop in operating profits from sales would correspond to a 75% drop in true profits.
3. The Credit Cycle
Much like the profit cycle depends on the economic cycle, the credit cycle is highly contingent on the economy. According to Marks, the credit cycle swings wildly in response to economic changes, causing credit to fluctuate from easily available to heavily restricted.
He explains that in times of economic prosperity, credit lenders often mistakenly believe that loans carry little risk, leading them to offer credit liberally to applicants. For example, start-up companies have little trouble securing loans when the economy is booming since lenders are overconfident that these companies can repay the loans. Consequently, creditors provide imprudent loans to unqualified applicants that carry a high risk of default.
As Marks relates, when borrowers eventually default on these unwise loans, it causes the capital market to overcorrect and become too restrictive. In other words, creditors become reluctant to issue further loans—even to qualified borrowers—causing the previously open stream of credit to dry up. The reduced availability of loans then feeds back into the economic cycle by slowing economic growth.
