I'm wired to be a contrarian. That means I tend to be early getting on and off trends. I was worried about the U.S. housing cycle in 2004 and thought the Rolling Stones were over the hill two decades ago (was I wrong?). I'm still calling for Cheez Whiz to make a big comeback (think Mini and VW Beetle).
Putting my tendencies aside, I have two hard and fast rules when it comes to economic and market cycles. First, it's impossible to time the beginning and end. And second, if the cycle has gone on for a long time and reached extreme levels (i.e. significantly above or below trend), then the retrenchment period will also take time and go to extremes.
These rules are applicable to all kinds of cycles and trends, including some of the current, long-lasting ones like housing (Canada good, U.S. bad), interest rates (31 years and counting), gold and China. As per Rule No. 1, we don't know whether these have years to run or have already turned.
Let me explain Rule No. 2 by first saying that all sustained up cycles, whether it's for a product, company, industry or country, are driven by strong fundamentals – favourable supply and demand; technological change; new markets; demographics and prior under-investment. As a cycle gets extended, however, it starts to pick up baggage that serves to magnify the unavoidable downturn when it comes.
For instance, it's often the case that the integrity of a cycle – what's behind the sales and growth – deteriorates as it gets extended. The quality of customer is poorer and more leveraged, and their reasons for buying are less about utility and more about chasing the trend. In the investment business, we talk about shares going into weak hands – buyers who aren't committed long-term holders and who may not know why they own the stock or how it's valued. As the adage goes, "What the wise man does in the beginning, the fool does in the end."
Weak hands and unknowing buyers are inevitable with the flow of good news that accompanies an enduring trend. More people hear about it and the media coverage and cocktail conversation is heavily biased to the positive. With time and attention, however, comes complacency. What is a cyclical upswing comes to be regarded as a secular trend, or even paradigm shift. What was an uncertain variable becomes a given. Participants are less prepared for a negative outcome because the risk factors are obscured. As a result, speculators play a bigger role. If leverage is involved, debt ratios go up. And portfolios get tilted heavily toward the prevailing trend (sometimes at the price of prudent diversification).
I've written about all of the cycles mentioned above with the exception of China. Its economy has been growing at 10 per cent plus. It has parlayed abundant, cheap labour and a supportive government into manufacturing dominance. And now the rural-to-urban migration is helping fuel the growth of the middle class.
Until recently, all the economic news on China was good. It was characterized as "an unstoppable machine." But the quality of growth has deteriorated. Wage inflation is starting to eat away at its competitiveness (although there's still a large cushion) and economic activity is increasingly being fuelled by easy credit and government-supported capital spending. (As an aside, China's unwillingness to tolerate a slowdown is reminiscent of the Bush/Greenspan era in the U.S.) It's widely accepted that China's next leg of growth will come from the consumer, but that transition is not yet happening as government subsidies and incentives continue to be funnelled in the direction of the inefficient state-owned enterprises.
As for complacency, news coverage on China is more balanced than it was a year or two ago, but still almost nobody can bring themselves to consider the possibility of a "hard landing."
Long cycles die hard. Whether it's China, housing or Cheez Whiz, the timing of the start and finish is unknowable. The outcome, on the other hand, is more predictable. The warning signs will be obvious in hindsight, stories of extreme hardship and bad behaviour will come out of the woodwork (and be the basis of many books) and the turnaround will take longer than expected.
With that conclusion, can you blame me for being early?
Tom Bradley