Projecting When Business Cycles Will Change

By Alan Beaulieu

Industries and companies do not operate in an economic vacuum; they move within a larger economic environment. Changes within that larger environment can significantly impact the growth probabilities of an industry and, perhaps more importantly, a company. Yet, despite the obviousness of this statement, many executives are so focused on day-to-day operations that they ignore the larger implications of general economic trends and thus risk making untimely and potentially costly decisions. This is a common, and highly preventable, phenomenon.

Perhaps an illustration would help. Pete was the president of his family-owned business. Sales were in excess of $10 million annually with a sales footprint that extended through most of the continental U.S. The company enjoyed healthy profitability over the last few years and was nearing the completion of a new manufacturing facility. Within a few months of moving into this beautiful facility, the U.S. economy slowed and demand for Pete's products dropped dramatically, seemingly over-night. Faced with high debt service on a new plant, rapid and painful cost measures were undertaken. The effects of these decisions would affect individuals for years and leave Pete to wonder how it could have been prevented.

What happened to Pete is in no way atypical. Business downturns surprise otherwise savvy business people on a regular basis. Pete was an expert at making widgets, managed people well and successfully marketed his company. What he failed to consider was the larger playing field called the U.S. economy. Had he looked at the business cycle trends, he would have known that a cyclical downturn was about to make its presence known in the U.S., and further analysis would have revealed that his industry was likely to be hit particularly hard. Armed with the broader economic outlook, Pete could have forestalled some decisions, made appropriate financing arrangements, trimmed overhead in a calm, planned manner, negotiated long-term contracts, spun off marginal business and otherwise positioned the company for the forthcoming economic downturn.

If he had known! One cannot afford to know which way the winds are blowing and fail to trim the sails accordingly. How can one effectively manage a business without knowing with a high degree of certainty what the future trend probabilities are? Simply put, you can only manage that which you know and are prepared for.

The Four Phases of the Business Cycle
Cyclical change is of a continuous nature. As measured by the rate-of-change, it is characterized by a rising trend that begins below 100 percent (below the 100 line on the chart) to a level above 100 percent (above the 100 line) followed by a subsequent declining trend to a level once again below 100 percent. It can be divided into four distinct phases. Knowing what phase of the cycle your business is in allows management decisions to be well timed. It becomes possible to plan for change rather than react to it. The right decisions can be made at the right time, without having to quantitatively forecast your business.

The chart illustrates the four phases of a 12/12 rate-of-change cycle. A cycle is measured from one cyclical low to the next, as opposed to peak to peak. The reasons for this designation have to do with the timing and dynamic characteristics of business cycles. For instance, there is much you can discern about the downside of the cycle based on the preceding rising trend; there is significantly less you can determine about the next rising trend based on the slope and duration of the declining trend which preceded the rise.

Characteristics of the Four Phases
Each Phase of the business cycle has some unique characteristics regarding the data trend and the business cycle psychology confronting you inside and outside of your company. Through an understanding of these relationships and attitudes, it becomes possible to utilize your knowledge of the business cycle to your advantage.

Recovery About to Begin
From the cyclical low up to the 100 line (inclusive) is called Phase A of the cycle. Throughout Phase A, the data trend is running below year-earlier levels. However, early Phase A signifies that the rate of recession in the data trend is diminishing; the slope of the downturn is approaching horizontal. The data trend can be expected to initiate a rising trend by the end of the Phase A portion of the business cycle.

Pessimism continues to be widespread during the early months of Phase A. Salespeople, managers, competitors and customers alike are very reluctant to acknowledge that the slowing rate of recession has meaning, let alone that a full-fledged recovery is at hand. Prices are at their weakest point of the cycle at this time, volume is down, and there have been previous false starts in the monthly data (which were unconfirmed by the rate-of-change and therefore ignored by you). It is in the first half of Phase A that the data trend for most data series will establish a low. The recession is over or very nearly so, and recovery has begun or is about to begin. It is time to take advantage of other people's pessimism knowing that you will soon be in a sustained recovery trend that will probably lead to company growth.

Optimism Reigns Supreme
Phase B of the cycle is when the rate-of-change is ascending above the 100 line. Sales are running progressively higher above year-ago levels. The data trend is experiencing its steepest portion of the rising trend. This is clearly the best portion of the business cycle.

Phase B does not last forever, although there seems to be an innate tendency on the part of most people to assume it will. Inadequate planning early on in the process of cyclical recovery can lead to a host of “positive problems” while you are in Phase B, particularly while you are in the latter stages of this phase. Positive problems are defined as anything resulting from the fact that you have too much business coming in the front door with too few resources to reasonably manage the business for profit maximization. Optimism reigns supreme during Phase B of the cycle. It is in the latter stages of Phase B that cash flow results in many expansion plans—which will come to fruition on the downside of the business cycle! (Remember Pete in the introduction?) Linear thinking can plague many a firm during this portion of the planning process for cyclical change. It is important to maximize the upside possibilities while at the same time recognizing that the current upturn will not last forever. (It never has before, why should it now?)

The Most Dangerous Phase of the Business Cycle
Phase C is when the rate-of-change has passed through a cyclical high and is descending toward the 100 line (inclusive). In Phase C, business volume is still higher than the previous year but the comparisons are becoming progressively less favorable. The data trend itself is slowing in its rate of ascent through the early portion of Phase C, depicted on a chart as a positive slope easing over toward a horizontal trend. The data trend will normally reach its own peak and initiate a recession before Phase C is over.

Phase C is without a doubt the most dangerous phase of the business cycle. Management, salespeople and customers have maximum optimism during this phase as new records of activity are achieved. There is a tendency to dismiss early signs of economic problems as temporary and of a nature which will be quickly and effectively dealt with. Capacity constraints are often realized at this phase of the cycle and new capacity is hurriedly planned and brought on line in the expectation that the good times will continue as long as customer demand can be met. In the history of business expansions, we can observe that the new capacity is often brought on line painfully close to when the rising trend reaches its peak and the downturn begins.

Unwarranted optimism is the psychological trait which characterizes this period. Prices are at their highest point for this business cycle and early in Phase C volume is still trending upward well above year-earlier levels.

Recession Leads to Pessimism
Phase D is the period characterized by the rate-of-change declining below the 100 line through to the eventual cyclical low. Business activity is running progressively below year-earlier levels. The recession is widely acknowledged. The plotted data trend is experiencing its steepest portion of descent.

Pessimism is the dominant trait of the decision maker in this phase of the cycle. Salespeople are reluctant to see improvement or opportunity. Competition may become increasingly a matter of lowered margins. Commodity prices in particular are taking hard hits during this phase of the cycle which compound volume declines which are already in progress. Generally speaking, an unanticipated downturn will turn out to be a severe recession. Being proactive to the downturn enables management to position the business for lower levels of activity with a lesser proportional hit on profitability. The transition from prosperity to recession can be orderly and therefore a mitigating factor on the dynamics of the recession.

In Phase C it is very difficult to convince people that the good times will not go on forever and that it would be prudent to plan in advance for the downturn. The converse occurs late in Phase D. It is difficult to accept the preliminary signs of recovery for what they are. There is an innate tendency to assume that the current trend is going to continue indefinitely. We have nearly as hard a time convincing people of an impending recovery as we do regarding an approaching recession. The business that can anticipate the low and be proactive to the recovery will be in the better position to service markets (proper inventories, salespeople, etc.) as soon as those markets begin to pick up, and salvage margins by recognizing that prices should be firming and the diminished margins of yesterday should be stabilizing today and growing once again tomorrow.

Not All Business Cycles Are the Same
Not all industries and/or companies experience all four phases in each business cycle. It is possible to move upward in Phase B, see decline in Phase C and then move upward in Phase B again without ever seeing Phases D or A. The factors determining whether this will be the case vary, but include where the industry/company is in terms of its life cycle, the overall pressures from the general economic environment, and at the company level, what management initiatives are being employed to diminish downside pressures and enhance upside potential.

Management's goal may be to never see Phase D and thus Phase A and sometimes this is possible. However, it should be remembered that profitability and market position can be maintained through proper planning and implementation of management objectives in those instances where the economy is dictating Phase D and then Phase A activity. Indeed, many firms regard Phase D and Phase A as periods of opportunity.

Identifying your current position is essential in order to determine which management objectives will be of greatest value to the company through the next half of the business cycle.