Monday, April 16, 2007

Business Cycles: Why They Exist

The economy, the stock market and each sector, industry and business all go through cycles of their own. What goes up must come down and vice versa. As an investor, understanding why cycles occur will help you to look at stock prices with an additional perspective.
One of the major reasons business cycles exist is because of a very fundamental fact: For physical goods, Supply cannot adjust to Demand instantly. Suppose for example, that there is a sudden surge in demand for a hypothetical brand of shoes called 'Royal Glamour'. At the shoe store level, the stock of shoes will run out and the store will call the shoemaker. The shoemaker will then need to make more shoes and order more leather for that. The leather maker will need to order more hides, the hide supplier will have to kill more cows. And when there are no more cows to kill, they will have to wait till cows reproduce and the calves grow up. In our hypothetical example, Demand for Royal Glamour shoes may have suddenly surged when Paris Hilton was seen on TV wearing them. But it takes some time for the Supply to adjust to Demand. This 'inelasticity' of Supply grows more serious for commodities, hotels, oil, ships, refineries etc and all those things which take a long time to make or to grow. When there is a tourism boom, and hotels run out of rooms to rent, businesses will plan to build more hotel rooms. But they will draw up their plans without complete information on the plan of others to do the same thing. And so, a building boom in hotels will begin. But when the hotels are ready in a year or two and come on-stream all at the same time, there will be a glut in hotel rooms. Same story applies to shipbuilding when freight rates go up, to the planting of corn to meet forecasted demand for Ethanol, and to the exploration, drilling and refining of oil. Real estate cycles are more pronounced than orange-juice cycles because supply of houses comes in bigger ‘lumps’ and takes longer to come on-stream while orange trees can grow in a few months and there are substitutes for orange juice.
(2) Because sellers cannot predict demand, they keep a stock of their goods [inventory]. But when Inventories are run down and re-stocking needs to be done, these 'uneven lumps' of demand from sellers also causes cycles along the whole supply chain. When the Demand for an entire industry is affected, for example by foreign competition, by new or substitute products, economic slowdown etc then the affected industry will also affect the companies who supply the input for its products. A good example of this lumpiness which causes distinct cycles is the defense industry which depends on government contracts. A sudden cut in the defense budget which terminates a military aircraft project will cause ripples in the whole supply chain as these are huge projects moneywise.

Therefore, cycles with peaks and troughs in prices exist because of the inelasticity of Supply and the existence of inventories. However modern economies have characteristics which mitigate the effects of business cycles. (1) As economies develop, the Service sector will overtake the Manufacturing sector to be the major component of the economy. In a developed economy, Manufacturing accounts for only 15-20 % of GDP, while Services account for about 70-80 %. Agriculture is the smallest component as about 2-5 %. Services cannot be stored and services are much more elastic in supply. A haircut is produced when a customer walks in. A doctor's services are generated when the sick customer comes in. Because of this, Services help to smooth the cyclical characteristics of an Economy.(2) The efficiency introduced by IT and the Internet, logistics, instant communications, and instant information helps to reduce holdings of inventory for manufacturing. Just-In-Time delivery of components or re-stocking by an efficient logistics supply chain also helps to reduce cycles in a business.(3) globalization and the free movement of goods, goods, capital and labor also makes business cycles less volatile. Lastly, a free market economy with less friction- in which businesses die, restructure, merge, and new businesses are constantly being created will adjust quicker to business cycles. This continuous process of ‘creative destruction’ was first named by the economist Joseph Schumpeter in his seminal work " Capitalism, Socialism and Democracy " published in 1942. The American economy best exemplifies Schumpeter's principle.
ValuEngine's Models take into account the cyclical behavior of stocks, industries, the individual business as well as the Economy. Below is a Table which shows the econometric forecasts for (1) Industries which are still in the doldrums[ Homebuilding,Computer Manufacturing], (2) Industries which seem to have re-structured and recovered (Airlines, Automotive Manufacturing * unfortunately an Industry Report for Automotive Mfr could not be generated by our Models because of insufficient required data. (3) Industries which have been performing well.

Airlines seem to have restructured and are poised for long period of growth.
Computer Manufacturers' outlook looks bleak. Perhaps its because its a low value industry where a computer has become a commodity with low prices and low margins.
Oil continues its strong run. Supply constraints include : dwindling reserves, lack of new- found fields, or new fields are in politically unstable countries, national oil companies demand a bigger share of revenue from the oil companies. Plus strong strong demand from China means that crude oil price price will remain high.
On the other hand, a look at the cycles in NonFerrous Base Metals and Base Metals show that demand can be met with more supply as new mines are commissioned or older one reopened. Finished Steel however maintains its strong growth. A significant portion of Steel demand is for specialty steel products in the growing Oil and Gas industries in the category known as Oil Country Tubular Goods [OCTG] from niche steel companies such as Lone Star Technologies [soon to be acquired by U.S. Steel], Ipsco and Tenaris SA
Drugs look interesting and have indications for strong growth from the 2nd year onwards.
Homebuilding at this point is still the worst industry forecasted.
*** Note that negative forecasts are always much less in % than positive forecasts. This is because of the creative destruction process as explained above, where anything that cannot survive will be allowed to die quickly or be reincarnated in a different form. Boom times typically last longer than deflationary times because: remedial monetary and fiscal action will be taken by the government, increases in productivity mainly because of improvements in Technology are ongoing, and the weak species of the business ecosystem are culled by the process of natural selection.

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