The Business Cycle Is Not Dead 21. October 2011 Rahul indian economy (0) Businesses, economies, nature and life move in cycles. Cycles are driven by reversion to the mean. If that was not the case, we would have a planet inhabited by 100 feet tall and 1 foot tall humans. Just like in times of euphoria, we forget that profits can fall, that growth can fizzle and that the party can end; in times of pessimism we forget that the reverse can happen. What drives the business cycle is imperfect information and the fact that markets are prone to overshooting. The world economy is undergoing acute deleveraging. Even though policy rates are at zero, innumerable small and medium businesses have almost no access to capital. Companies all over the world are burning through equity at an alarming rate, with no ability to raise new capital. This is likely to lead to a very high level of supply impairment and a lot of good supply will get destroyed in the process. At some point supply will fall below bottom-of-cycle demand. This will give tremendous pricing power to the survivors; any uptick in demand will then lead to high inflation. Over the last two decades, some of the potential pricing power for companies was sapped away by excessive capacity creation in China. China, however, is now an exporter of inflation and not deflation. We will be served well to study the business cycles of the 1970s and 1980s to understand likely outcomes. From an investors point of view, the biggest returns are made by buying at high PEs at the level of the cycle when pessimism is highest. The equity market investment cycle follows four stages: - First losses turn into earnings and PEs contract - Then earnings grow and stocks rise with marginal re-rating of PEs - Then earnings stabilize but PEs continue to expand as markets become euphoric and everything gets re-rated - And finally, the cycle reverses with downward earnings surprises, followed by collapses in PEs The high level of corporate stress will therefore result in windfall gains for survivors not too far in the future. Obviously as an investor the key is to not invest in companies that become casualties of the down cycle.