Editor's Note: We are pleased to present this special Contributor View written by Doug Cliggott. Mr. Cliggott is a former U.S. equity strategist at Credit Suisse and chief investment strategist at J.P. Morgan. He is currently a lecturer in the Economics Department at UMass Amherst. Incidentally, he recently sat down with us here at Hedgeye for a Real Conversations interview. Click here to watch.
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By Doug Cliggott
Business cycles in America follow a distinct pattern. At the beginning of the cycle, as the economy climbs out of recession, corporate profits begin to grow. The behavior of both bankers and their corporate clients remains cautious, because memories of recent declines in financial asset prices and business activity are still vivid memories.
As the economic recovery continues, realized profits continue to beat still-subdued expectations, and slowly but surely optimism builds. It takes some time, usually a few years, but eventually “animal spirits” are ignited, to steal a phrase from John Maynard Keynes. Corporations become more willing – even eager -- to invest and to borrow. Bankers become more willing to lend, and investors become more enthusiastic about buying equity shares of “seasoned” public companies as well as shares of newer ventures making their initial public offerings.
This process becomes self-reinforcing as higher stock market values encourage firms to borrow more and bankers to lend more. But this process doesn’t go on forever. Economic expansions in America are measured in years, not decades. The reason is simple. Bankers, investors and managers of non-financial companies are just like you and me – they are human. They make mistakes.
We all have a strong tendency to extrapolate the present into the future. When things are going well – when sales and profits are beating expectations and stock prices and corporate bond prices are climbing – we expect these trends to continue and we make decisions about the future based on these expectations.
But inevitably, some of these more optimistic expectations prove to be misguided. Some of the new investments by businesses earn less than expected, maybe because sales disappoint or a new product fails to catch on. In the stock and bond markets, some prices start to fall. The price declines are few at first, almost imperceptible, since the broader market indices usually continue to climb in this phase of the credit cycle.
As time moves on, the weight of our collective errors in judgment multiply and the declines in corporate earnings become increasingly widespread. As do the decline in the prices of financial assets linked to those earnings
Tracking our location
One clear way to track the “status” of American credit cycles is to compare the growth rate of corporate profits with that of corporate borrowing. Profit growth in excess of borrowing growth is a powerful signal of a sturdy economy since it indicates that the fruits of new investments are – in a very broad sense – exceeding expectations. Or put another way, we have collectively not yet become overly optimistic about the near future.
Conversely, when these growth patterns trade places, when the pace of borrowing by non-financial corporations accelerates to the point that it exceeds the growth rate of profits, that tends to be a signal of trouble ahead since it indicates that optimism may have become excessive and that it will become difficult for an increasing number of borrowers to pay back their loans if they continue to increase borrowing at a rapid rate.
This part of the business cycle also takes time, often years, to play out. One way to think about it may be what happens on a commercial aircraft when the pilot informs us that we are leaving our cruising altitude. The “fasten seat belt” sign may not be illuminated right away, and the ride is typically still nice and smooth. But in a very real sense, the flight path we are on has changed. The decent has begun – we are in the final phases of our flight.
Changes in the American economy’s flight path – to an environment where corporate borrowing growth exceeds profit growth -- happened in 1998, it happened in 2007, and it happened again in 2013. What follows – sometimes immediately, but typically in a year or two – is an increase in financial market volatility, then a decline in corporate profits and stock prices followed by a contraction of business investment and employment, and increases in business failures and loan defaults.
To repeat, this sequence of events occurs repeatedly because borrows, lenders and investors of all stripes make errors in judgment. And we tend to make mistakes that involve borrowing too much money, or paying too high a price for a corporate bond or shares of equity in a corporation, when we are over-confident and budding with optimism. And these types of mistakes tend to dominate when a cycle is comfortably mature, not at the beginning of the cycle when we are usually too pessimistic and often outright skittish.
Keeping score
Looking back at the past six decades, we see a neat symmetry. There is an even split between years when profits of nonfinancial companies grew at a faster rate than their liabilities (31 years) and years when the opposite was the case (31 years). {See Table 1.}
The performance of U.S. equities is not nearly as symmetric. Equity prices declined during just sixteen of these sixty-two years, or roughly twenty five percent of the time. More to the point -- eleven of these sixteen negative years occurred during periods when debt growth exceeded profit growth, and three more (1962, 1981, 2002) happened in the first year of a period when profits grew faster than liabilities.
So not surprisingly, observed equity price declines are a recurring feature of the phase of the credit cycle when excitement and optimism turn to disappointment and pessimism. Sadly … that appears to be exactly where we are right now.
