What Goes Up

We have a mantra in our household: Where we are now is not where we're going to be tomorrow. It's meant to remind us that good times won't last forever, so say thank you. It's also meant to remind us that bad times won't last forever, so breathe and hang tough.

You might also want to adapt this mantra if you're an investor since it's equally applicable in terms of understanding business cycles. We investors have a tendency, when times are good, to think that they will always be good. When interest rates are low, we think interest rates will always be low. And when the economy sucks,  well… you get my drift.

The reality is very different. Free market economies regularly move through phases of expansion and contraction.

When a business cycle is in an expansion phase, jobs are created and incomes usually go up. The increased prosperity gives consumers loads of confidence so they go out and spend loads of money.  All that spending drives the production of more goods and services to keep up with the demand, further fueling the economic expansion. That over-demand and under-supply can fuel increase in prices. When those prices hit some magic number – a tipping point – consumers pull back. Now companies are left with an over supply of their products and services so they, in turn, pull back, cutting production to reduce inventory and laying off workers. This is where the expansion phase turns to the contraction phase.

When the business cycle is contracting it's because sales and incomes are generally falling and unemployment is increasing.  Consumer confidence is nowhere to be seen so people start to squirrel away a little money because they now believe the worst can happen. Governments usually step in to stimulate spending or hiring and try and mitigate the impact of the contraction.

If the trough is deep enough, it's call a recession. Typically, during a recession, production as measured by GDP falls. Business profits fall. So too does employment and, as a result, household incomes. All this results in lower inflation, higher levels of bankruptcy and increased unemployment.

What is GDP? Gross Domestic Product (GDP) is one of the primary indicators used to gauge the health of a country's economy. It represents the total dollar value of all the goods and services produced during a particular period of time. At its most basic (because the calculation is actually quite complex) GDP is calculated by adding up what everyone earned in a year including total compensation to employees, companies' gross profits, and taxes (less subsidies). Or, more commonly, it can be calculated by adding up what everyone spent in a year, including total consumption, investment, government spending and net exports. When you hear that GDP has risen by 2% over the past year, it means economy has grown by 2%.

If the trough is deeper still, it's called a depression.  While there's no universally agreed upon definition for a depression, one rule of thumb used is that a depression is a period during which GDP declines by more than 10%.

There's an old joke amongst economists (who are, by nature, not particularly funny):

A recession is when your neighbour loses his job. A depression is when you lose your job.

Ultimately, like the sun rising or the seasons changing, the business cycle will shift, moving once again to expansion. Unlike the seasons changing however, there is no regularity to the business cycle, which is one reason why we poor fools keep getting sucked into believing that things will never change. Cycles vary in length. Cycles vary in intensity. But while we can never predict the longevity of a current cycle, it behooves us to keep in mind that what goes up must come down. And vice versa.

Share this on Facebook


Share this on del.icio.us


Digg this!


Share this on LinkedIn


Stumble upon something good? Share it on StumbleUpon


Tweet This!


Subscribe to the comments for this post?


Email this to a friend?