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As the Cycle Turns

It may be time to start paying more attention to the business cycle.

Anxiety rippled through Corporate America last February when the U.S. Department of Commerce issued its latest report card on the economy — a mere 1.6 percent GDP growth for the fourth quarter of 2005. That was the slowest growth in three years. But economists generally remained optimistic, predicting that the economy would rebound in 2006. Few saw much trouble in the cards, let alone the “R word” — recession.

The problem is, most economic forecasters don’t see recessions coming until it’s too late. Their methods work when the economy is stable, but even the most complex econometric models are blind to sudden turns in the business cycle. According to The Economist, 95 percent of U.S. economists in a March 2001 survey saw nothing but growth on the horizon, when a recession had started that very month.

Consensus forecasts also predicted growth at the onset of recessions in 1981 and 1990. Each recession, it seems, tells a different story, which few can read in advance. And each business cycle is unique, however periodic companies would like them to be. Recognizing the difficulty of predicting the future, most companies no longer employ staff economists, outsourcing their forecasting needs to commercial firms and university-based centers. “The profession of macroeconomic forecasting is currently stuck in a long, protracted recession with no trough in sight,” writes Cornell College professor Todd A. Knoop in his excellent scholarly introduction to business cycles, Recessions and Depressions: Understanding Business Cycles (Praeger, 2004).

Do It Yourself

But the perils of economic forecasting haven’t put a damper on popular books about the subject. Recent books like Bernard Baumohl’s The Secrets of Economic Indicators: Hidden Clues to Future Economic Trends and Investment Opportunities (Wharton School Publishing, 2004) maintain that people can learn to be their own forecasters — and hence better investors, entrepreneurs, and managers — by monitoring the right economic data.

In Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles (Harvard Business School Press, 2005), Joseph H. Ellis, a former retail analyst at Goldman Sachs, argues that consumer spending is the master key to forecasting. Since consumer spending accounts for about two-thirds of GDP, wherever it goes, the rest of the economy must follow. “If we can successfully predict turning points in consumer spending, we can also successfully predict inflection points in the economy at large and, often, the stock market,” he writes. The best leading indicator for consumer spending, in turn, is real average hourly earnings, says Ellis.

Ellis isn’t an economist and doesn’t claim to have a perfect forecasting record. But he says his methodology, developed over a long career on Wall Street, served him well (Ellis was Institutional Investor’s top retail analyst for 18 straight years). Surely it can’t hurt to keep a weather eye on consumer spending, or to seek, as he suggests, leading indicators for one’s business or industry sector.

Above all, Ellis insists that companies should drop the “recession obsession” and watch instead for trends and turning points. Two consecutive quarters of negative GDP growth (a common definition of recession) “typically follows 18 to 24 months of a declining rate of growth,” he told CFO. It’s during that earliest stage, Ellis points out, when much damage is done — misguided investments, ill-advised capital expenditures, inventory buildups.

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