July 2016 — Every individual, business, and political entity experiences periods of prosperity and deprivation, and periods of economic ascent and decline. Alternating periods of expansion and decline in economic activity make up a business cycle. Business activity cycles and recycles throughout the life of a market-driven economy. These cycles take place on microeconomic and macroeconomic levels. The microeconomic market includes the small-scale economic activity of individuals and businesses. The macroeconomic market includes the large-scale economic activity of governments. Several centuries of increasingly sophisticated empirical analysis have confirmed that cycles exist, and many theories have been devised to explain the timing, height, depth, and duration of business cycles. It is evident that there are multiple business cycles and that they do not occur in tandem with one another.
In a perfect world, where all activity works in tandem, the periods of prosperity and deprivation in the business cycle would occur at evenly spaced intervals, and the periods of ascent and decline would be smooth and uniform. Precise prediction of events and timing would be possible, and the economy could be managed with precision. Under such conditions, risk could be eliminated, and economic certainty would become the norm.
However, this is not economic reality. Economic change is not uniform, and its predictability is uncertain at best. Periods of economic expansion in the United States since the Civil War have ranged in length from approximately ten months to as long as 120 months. Periods of decline have ranged from as few as seven months to about 65 months. Similarly, the high and low points of expansion and contraction have not been evenly balanced. The more irregular the cycle, the greater uncertainty becomes. Greater uncertainty increases the level of risk. It should also be noted that the real estate cycle lags behind the general business cycle with deeper troughs and higher peaks.
Additional complexity exists within the cycle itself. Short-term investments are inherently more predictable. Investments of this type are normally created for a term of one year or less. Short-term investments respond to short-term cycles. For example, if market interest rates change significantly because an investment is short term, the investor can either take advantage of an increase in interest rates or suffer a reduced yield if interest rates decline.
Conversely, long-term or illiquid investments are subject to a long business cycle of 30, 40, or more years. Returns on these investments can be astonishingly large when held through their entire lifecycle. However, if adverse circumstances force a sale of the asset before maturity, the owner may sustain severe loss of capital.
Intermediate-term investments exhibit some characteristics of both short- and long-term commitments. Although intermediate investors may run less risk of capital loss than long-term investors, they may also experience lower yields. In addition, intermediate investors do not possess the flexibility of short-term investors. This observation leads to a generalization about yields on investments. Typically, yields on short-term investments are lower than on long-term investments.
Another observation can be made concerning interest rates: In general, as short-term market interest rates fluctuate, they affect the value of long-term assets if those assets must be sold. If market interest rates rise, the principal value of long-term assets tends to decline. Conversely, if rates fall, the principal value of these assets rises. We can conclude, therefore, that an inverse relationship usually exists between market interest rate yields and long-term investment values.
While a number of means exist for tracking not only interest rates but also the factors that affect the business cycle, the Internet has made tracking and gathering this information instantaneous. Traditional print and industry sources such as the Wall Street Journal, Barrons, and Dow Jones, along with a host of others, have websites where both daily and historical information can be obtained.
Composite indexes are also available. The Conference Board, for example, lists leading economic indicators and related composite indexes for the U.S. economy. Their ten leading indicators include not only such measures as the interest rate spread on ten-year treasury bonds and stock prices, but also other variables such as consumer expectations and building permits.
Measuring the extent and timing of the business cycle can mean success to the investor whose timing is correct and disaster to the investor whose timing is incorrect. Therefore, it is important to understand expectations and their effect upon investment decisions.
In the economic sense, expectations are a rational understanding of the variables that shape the economic conditions that affect our lives. A consumer, for example, might purchase an automobile before an anticipated period of inflation produces higher prices. A lender who anticipates higher interest rates might delay making an otherwise acceptable loan until the rates rise. Conversely, an investor intending to leverage a purchase may anticipate a reduction in interest rates and might therefore delay making the purchase until the interest rates are lower.
To a great extent, individuals base their personal consumption and investment decisions on their expectations. These expectations, in turn, are influenced by an individual’s lifestyle, goals, concept of culture, and prejudices. Businesses operate in much the same way as individuals. Expectations will influence a business’ sense of purpose—known as the corporate mission. At the macroeconomic level, governments also base decisions on their expectations.
Economic uncertainty and expectations, clouded by prejudice and corporate mission or political issues, give rise to increased risk. Attempts must then be made to understand, evaluate, minimize, or mitigate risk. Risk, in the statistical sense, is the likelihood that a possible outcome will take place. Risk, in the human sense, is taking a chance that involves the possibility of reward if a decision is correct and loss if it is incorrect. Economic risk involves aspects of both statistical and human risk.
The risk of loss in the business world can be truly enormous. More than one half of all business firms fail within two years of start-up. The failure rate for firms that are particularly sensitive to the business cycle or competitive pressures can be much higher than 50 percent. Organizations dependent on natural resources and firms employing pioneering technologies are examples of businesses with extraordinarily high failure rates. Similarly, businesses that are highly leveraged, and therefore at the mercy of interest rate fluctuations, experience a higher failure rate. The interest rate changes create additional market risk because of higher capital costs.
The more accurately you quantify and evaluate risk, the greater your ability to devise methods of diminishing it. When risk is minimized, the probability of a profitable investment outcome increases, as does the productivity of resources. The first step in evaluating risk is to understand the investment alternatives available and how they may be used and abused.
This article is adapted from BOMI International’s course Real Estate Investment and Finance, part of the RPA and FMA designation programs. More information regarding this course or the new High-Performance certificate courses is available by calling 1-800-235-2664. Visit BOMI International’s website, www.bomi.org.