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.
A Feel for the Economy
Peter Navarro’s latest book, The Well-Timed Strategy: Managing the Business Cycle for Competitive Advantage (Wharton School Publishing, 2006), is mostly about managing, not forecasting. A professor at the University of California, Irvine’s Paul Merage School of Business, Navarro contends that every function of the corporation — from finance to marketing and human resources — should be conducted with respect to the business cycle.
Accordingly, his book is replete with examples of companies that “manage” the business cycle (“master cyclists”) and companies that run afoul of it (“reactive cyclists”). Master cyclists pull back on capital expenditures before recession strikes, as Johnson & Johnson did in 1999, or invest countercyclically in advance of a recovery, as Intel did a couple of years later. They cherry-pick other companies’ cast-off talent during hard times. They time acquisitions and divestitures to the cycle, buying cheap and selling dear, and tactically hedge interest-rate and commodity-price risks according to the cycle’s phases.
The most sophisticated master cyclists hedge risk through business-unit and geographical diversification. Running a company with the business cycle in mind, Navarro told CFO, is akin to playing poker, where players “can manage their bets and shift the odds in their favor.”
As for forecasting, Navarro recommends conventional tools — leading indicators, the yield curve, oil prices, and so on. He also advises CFOs to use a stock simulator to maintain a mock portfolio. “It’s a great way to keep in tune with financial and business-cycle conditions,” he says. “The more you practice, the more you develop a feel — it is a feel — for which way the economy and markets are going.”
Two more of Navarro’s favorite forecasting tools are the weekly leading index and future inflation gauge published by the Economic Cycle Research Institute (ECRI). The forecasting firm was founded by the late Geoffrey H. Moore, a pioneer in the study of business-cycle indicators.
Today ECRI monitors some 20 indexes of leading indicators, says Lakshman Achuthan, its managing director and managing editor. Globally, the firm also maintains indexes for 19 other economies. Achuthan and Anirvan Banerji, ECRI’s director of research, describe the firm’s approach to forecasting in Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy (Currency Doubleday, 2004).
ECRI has an enviable forecasting record. It called the 1990 and 2001 recessions five and six months in advance, respectively. Between those downturns, the firm didn’t forecast recessions in 1995 or 1998, when others did. “Not making a recession forecast is as important as making it,” comments Achuthan. ECRI also divined the growth without inflation of the 1990s and the so-called jobless recovery of this decade.
Most managers’ “eyes glaze over” when it comes to economic forecasting, concedes Achuthan, but they ought to take it seriously, he adds. “Whether they’re doing it explicitly or implicitly, I think CFOs have different scenarios about what might happen,” he says. “Recognizing that all of these economic scenarios don’t have the same probability can save them money or investments or time.”
What does Achuthan forecast for the year ahead? “The first half of 2006 won’t be bad. In the second half of the year” — which is about as far ahead as ECRI can “see” — “home prices will put a drag on consumer spending. At the same time, we see a global industrial slowdown, across all major economies. As a result, the ride gets a little bumpier.”
And what about the “R word”? “There’s no recession in sight,” says Achuthan. “We should make it to the sixth year of expansion at least.”
Edward Teach is articles editor of CFO.
Ups and Downs
The business cycle since World War II
|Dates of Contraction
(Peak to Trough)
|Duration*||Dates of Expansion
(Trough to Peak)
Source: National Bureau of Economic Research