Leveraging business cycle ups and downs.
* Every executive can learn to forecast the business cycle; and
* Competitive advantage can be gained by combining this forecasting ability and business-cycle appropriate strategies.
Many financial executives reacted to the severe recession like captains of a sailing ship caught in an unexpected storm at sea: Batten down the hatches, pull in the sails, ride it out.
In contrast, a few executives seemed to possess an uncanny ability to not only see the tempest coming, but to actually harness the recessionary winds to speed past their foundering competitors. Such captains of industry maintain robust profitability and enjoy higher share prices right through recessions--and their companies emerge stronger.
An extensive study into this phenomenon was conducted by the authors at the Paul Merage School of Business at the University of California, Irvine. The goal was to identify winning companies and isolate the strategies their executives employed.
Empirical results of market performance for firms using the forecasting framework were clear: They tend to enter downturns with more cash, lower overhead and a leaner payroll.
In the depths of a recession, these companies eagerly but up materials, suppliers, competitors and facilities on the cheap.
They use the pain of high unemployment to grab the best talent at the best price and actually expand their advertisting in the relatively uncongested ad market.
They adroitly increase their capacity and seize market share in preparation for the inevitable upswing and take the opportunity to reinvest and reinvent when expectations are low and the pressure for short-term financial performance is lowest.
The research-based framework involves three steps for achieving superior performance over the course of the business cycle:
1. Develop internal forecasting capabilities and communicate the results to executives;
2. Correctly apply counter-cyclical business cycle management strategies; and
3. Build a business culture that integrates business cycle management thinking.
Forecasting and the Most Critical Indicators
Though financial executives often take full-length courses on how to forecast the business cycle, some of the key points can be covered here. For starters, one of the most important incentives for every executive is that successful forecasting requires a continual reassessment of all the economic indicators under consideration. In other words: If the forecasting unit comes up with a projection for the quarter--or if it comes from an economic forecaster at a conference--don't bet the company on it.
While such forecasts are often very good, economic winds do change and three or six months later, that same forecaster would very possibly advise a new direction in order to accommodate the change. This point also underscores the importance of quickly communicating new economic information to all decision-makers within the company.
The central tool to becoming a successful economic forecaster is the famous "GDP equation," first set forth by the Depression-era economist John Maynard Keynes. The real, inflation-adjusted gross domestic product is used in every nation to measure the health and growth of the national economy. It is driven by four easy-to-follow components: consumption (C), business investment (I), government spending (G) and "net exports," which is the difference between exports (X) and imports (M).
Thus, the Keynesian equation may be written: GDP = C + I + (X-M) + G.
Exhibit 1 (above) provides an overview of the forecasting model and the 11 leading economic indicators and economic reports that may be used by you and your executive team to track movements of the GDP.
It must be stressed that following these components will take no more than five-to-10 minutes a day. In today's dynamic economic environment, forecasting must become an important part of the job of every financial executive.
The ECRI Index
As for the predictive power of this model, consider, the ECRI Weekly Leading Index, which is released each Friday by the Economic Cycle Research Institute. This is a well-tested indicator that has accurately signaled each of the last three recessions going back to 1990--without any false signals.
Exhibit 2 (see next page) indicates that the ECRI index would have given a full six months warning of the 2007-2009 crash. The purple line clearly began to head south in June 2007. By December, it was at a record low and the commentary read: "Also, the breadth of deterioration evident in the latest data on the components of ECRI's many leading indexes has rarely been seen except near the cusp of a recession." Yet, despite the ECRI index's warning sign, government economists and the consensus opinion were still unwilling to admit to a recession.
The Yield Curve
The yield curve spread is an equally powerful recessionary signal. This indicator, which measures the yield spread between the 30-day Treasury bill and the 10-year Treasury bond, likewise has accurately signaled the last three recessions.
The logic of the yield curve as a leading indicator is well worth understanding. Investors expect higher rates of return when they commit their money for longer terms. Hence, the yield on the 10-year note almost always exceeds that of a three-month bill and the curve graphing those yields slopes gently up from shortest to longest term.
However, if bond traders begin to believe that rates will be dropping significantly in the future because they see a recession ahead, they are likely to want to "lock in" today's relatively higher yields for as long as possible. When this occurs, the yield curve "inverts" and demand for the long bond drives yield on the long end down below short-term yields. In this way, yield curve reflects the consensus of the real money bets of the world's brightest speculators on a recession.
Note that the green line in Exhibit 2 charts the "spread" in yield (difference in percentage points) between the 30-day Treasury bill and the 10-year bond over the recent past.
Normally, it is well above zero. But each time the line drops below zero (on the right axis) the spread is negative and, at least for the last three occurrences of this inverted yield curve, a recession has followed.
For example, Exhibit 2 shows that the spread drops into negative territory in August 1989 and recession follows the next July. In July 2000, it signals the March 2001 recession. In August 2006, it signals 2007's downturn.
In fact, the yield curve spread has called the last six out of seven recessions without a false positive. It follows that the odds of your own forecasting using the yield curve should be pretty good because you are learning from some of the smartest money managers on the planet--professional bond traders. (For more information on the yield curve's predictive powers, see "The Living Yield Curve," at the SmartMoney Web site www.smartmoney.com/Investing/Bonds/The-Living-Yield-Curve-7923.)
At this point, one might be thinking: If GDP forecasting tools like the ECRI Weekly Leading Index and the yield curve spread are so accurate, why bother with the right-hand side of the GDP equation and with tracking consumption, business investment, net exports and government spending?
That's a good question. A really good answer is that any recession can be triggered by any one of these four GDP components.
This is a critical observation for financial executives because they far too often focus too narrowly on their own industry indicators for guidance. That's fine if a recession is going to be triggered by a sharp drop in business investment, as was the 2001 recession. However, it can cause real trouble if a recession is consumption-led, like the 2007-2009 crash.
The broader point is that following the four components on the right-hand side of the equation provides a better early warning system than following direct GDP indicators alone. Here is more detail on some of the indicators used in the forecasting model:
* Consumption. The Consumer Confidence Index indicates where short-term consumer thinking is while retail sales directly measure what consumers are actually spending. In addition, new home sales represent an excellent gauge of how consumers feel about the long-term prospects for growth.
* Business Investment. There are a lot of business investment measures, including factory orders, capacity utilization and durable goods. For the time-pressed financial executive, it's more than sufficient just to follow one indicator: The Institute for Supply Management, or ISM manufacturing index.
* Net Exports. The bad news here is that there is no single indicator to follow. Instead, it is critical to review the monthly Trade Report issued by the Department of Commerce. To economize on time for this, consider using Moody's "Dismal Scientist" Web site for its regular analysis. This site also offers a "one-stop shop" for monitoring all of the indicators in the forecasting model. (See http://economy.com/dismal/navarro to find all these indicators in one spot.)
In reviewing the Trade Report, it is critical to understand basic economic concepts such as why the balance of export/imports changes. Some movements are due only to short-term interest rate changes and collateral exchange rate movements. Others may be triggered by a price spike in a specific commodity (usually oil). These factors can produce abrupt and significant, but often-fleeting, changes in the net export numbers. Only in context can their significance be judged.
For example, low interest rates in the United States during the last boom depressed the dollar and sustained U.S. exports to Europe, at a cost to the European economy. European consumption inevitably slowed and this export advantage evaporated. Oil price shocks drive imports up and have been associated with almost every recession in modern history.
Business Cycle Management: What to Do, and What Not To Do
Once you become adept at economic forecasting, you will be able to nimbly execute a set of battle-tested and typically counter-cyclical strategies over the course of the business cycle.
When it comes to the strategic part of business cycle management, the conventional executive wisdom is often toxic. Here, simply avoiding the reactionary pitfalls that ensnare the normally cost-conscious chief financial officer is a great first step. Indeed, if you can learn to simply avoid these behaviors more than half the battle will be won.
Just what are these bad reactive behaviors? As was mentioned in the introduction, the winning executive sees recessions coming, gathers cash at the market top and pounces on the advantages of lower costs and reduced competition to acquire the best assets, hire the best people and conduct the most cost-effective marketing campaigns.
Rather than slashing, this astute business cycle manager is leasing, building, hiring and expanding advertising. This executive knows that recessions rarely last more than a year or so and they look at each recession as an opportunity to thoroughly pound their clueless, reactive competitors.
It's not just falling into such a reactive trap that must be avoided. Exhibit 3, opposite, illustrates the timing of several critical proactive strategies employed by the winning companies in the survey.
Chill With the Freeze
Another favorite tool of a reactive-type executive is the "hiring freeze," which is also one of the most pernicious habits of the stereotypical "bean counter" mentality. Consider the position that a freeze puts managers in. It sends the message that they cannot be trusted to manage when it really counts and if that is the case, there might be questions about why they are still receiving management wages.
If this were the only problem with the freeze, it would be bad enough. However, such a move also unintentionally establishes a perverse set of incentives. Among the unintentional consequences of a freeze is that managers will virtually never fire anyone or let them leave. Fearing that even the worst employee is better than no employee, they will work to retain individuals who are clearly performing below corporate standards.
As such, managers are driven to conceal the failings or infractions of these individuals to protect their headcount. With fudged performance reviews, the worst employees gain eligibility for promotions, raises and even bonuses. As this becomes obvious to their peers, morale suffers. In the same vein, managers may actively impede promotions and lateral transfers, even if these moves are in the best interest of the firm. Corporate efficiency will suffer and morale will again suffer.
In such a scenario, the attitude of managers will not be better. The public diminishment of their authority will grate against their egos, the requirements to compromise their principals for headcount will degrade their integrity and the ensuing alienation from an increasingly disgusted staff erodes their job satisfaction.
The hiring freeze is never a winning strategy, and it's also a notice for the brightest employees to start printing their resumes on company time--with the best managers right behind them. In contrast, hiring qualified managers, trimming through attrition before recessions and trusting managers to manage their business is the sound way to control human resources costs.
Managing Capital through the Business Cycle
Any financial executive knows that the cost of capital varies over the business cycle. For example, borrowing costs are typically lower during a recession. Thus, recessions can be a great time to invest in new capital equipment.
Recessions can also be a great time to acquire rivals or suppliers, particularly since these acquisitions are often selling at bargain prices. With such a counter-cyclical acquisition strategy, cheaper financing is simply icing on the cake.
Meanwhile, the reactive managers are loaded with expensive debt from ill-timed investments made at the height of the previous expansion; their weakened companies may even be the acquisition targets of their stronger, more business cycle-savvy rivals.
On the long-term debt front, those financial executives prepared for any cycle are likewise ready to lock in long-term debt during downturns, when it is cheapest. They are also astute enough to utilize shorter-term borrowing in expansionary periods when rates are higher. If it is necessary to raise cash or make acquisitions during an expansion, the best choice is often to use equity while company stock is most highly valued.
Carefully timing equity offerings and borrowing options to coincide with the business cycle saves large companies millions a year and even very small organizations can benefit by managing their credit lines most effectively. Gaining the skills to forecast the economy makes timing these operations much more practical.
Those who truly understand capital management that is sensitive to business cycles have moved on to an even higher level and realize that the spread between short-term and long-term debt often varies in reaction to the business cycle and the Federal Reserve's manipulation of the markets. The Fed's target interest rates are achieved via its "open market operations," which consist primarily of trading overnight repurchase agreements, known as "repos."
These operations are very effective in quickly pulling short-term rates to the Fed funds target rate. The actual policy goal is to affect long-term interest rates on capital equipment and property financing, which are normally down during a recession. However, there is often a significant lag in the long-term market's response, which increases the previously mentioned spread. This is exploited by those in the know.
For instance, following the 2001 recession and the 9/11 terror attacks, the General Electric Corp. greatly increased its percentage of ultra cheap short-term debt. Chief Executive Officer Jeff Immelt and his team correctly forecast that the rates were not likely to rise significantly for a while and reasoned they would be able to turn these short loans over and over, rather than pay for the comfort of the long-term rate.
Despite some very public criticism from traders who didn't understand the underlying strategy, this $100-billion play saved GE hundreds of millions of dollars. While not for the weak of heart, watching this spread, anticipating where the business cycle is headed and carefully managing the ratio of short to long-term debt can certainly bear fruit.
Learning to forecast and implement the strategies described here will give financial executives and their organizations the ability to become top competitors. That may be the easy part.
In fact, over time the heavy lifting will be in educating the CEO, board members and fellow executives on the need for each of them to become economic forecasters. The goal is to have this attitude permeate the organization--and thereby cultivate a business cycle management culture.
If every executive and manager becomes a forecaster and information is pooled and communicated to the right parties, the correct business cycle management strategies can be effectively executed in a timely manner. In such a manner, this management approach can be woven into the fabric of an organization, from top to bottom. The goals? To turn the next recession into a winner for your firm. And to avoid getting caught if the latest "recovery" turns into a double dip recession as well.
Did the recession take a big and painful bite out of your bottom line?
Are you now asking, "Is this current recovery real?" If so, how can your company take advantage of it?
And, importantly: How can you foresee the next recession coming?
GREG AUTRY (firstname.lastname@example.org) is an entrepreneur, author and Ph.D. student at the Merage School. PETER NAVARRO (www.peternavarro.com) is a professor at the Merage School of Business of the University of California, Irvine and author of several books including his recent Always a Winner: Finding Your Competitive Advantage in an Up or Down Economy, published by John Wiley & Sons, 2009.
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|Title Annotation:||COVER STORY|
|Author:||Autry, Greg; Navarro, Peter|
|Date:||Dec 1, 2009|
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