The Resurrection of Risk : Part 3

Beating the Business Cycle
by Lakshman Achutha, Anirvan Banerji

(Page 3 of 3)

As long as the economy is proceeding in the same general direction, you can easily adjust major business decisions, such as whether to expand your company, hire new employees, or implement cost-cutting measures; in your personal life, you can postpone or accelerate major decisions such as buying or selling a house or changing jobs. But as a turning point in the economy approaches, the gap between reality and one's expectations can lead to painful consequences, and you can find yourself quickly heading in the wrong direction.

During the downturn of 2001, many businesses and individuals experienced this devastation firsthand. The severity of the drop was worsened by the extent to which CEOs believed the hype that recessions were a thing of the past. The fiber-optics and telecom industries built up tremendous overcapacity as a result. Cisco Systems, for example, continued to order equipment from its vendors long after customer orders began to dry up. The bust, in effect, was ensured by the growing dismissal of risk, which led to reckless behavior.

When business leaders, the media, government officials, economists, and individuals make such mistakes together, things go wrong in a big way. A herd mentality takes over and otherwise sane and rational people do crazy things. This tendency lay at the foundation of the biggest stock market bust of our generation. The urge to believe that the future would be like the recent past, combined with a kind of mass euphoria, blinded people to the possibility that the economic times may change.

If bullish behavior during booms and bubbles feels rational at the time, so can pessimism and anxiety during downturns. Like it or not, our assessment of the future is colored by emotion. Subjective interpretations are driven by both the recent past and the prevailing wisdom, and will always lag at economic turning points. Although many people were hurt when the economy turned down, as time passes those scars, too, will fade, and caution will eventually again give way to complacency. When the next recession hits, most people, oblivious of the turn in the cycle, will make the same mistake as before. In the same way, we may, with the recent recession in mind, fail to take advantage of the next boom in the economy. To break from this pattern of basing economic decisions on the recent past, you need to use a decision-making framework that can see through the delusions of the crowd, and anticipate the next turn in the economy.

Good judgments are easy to make after the fact. But it is difficult to make the right decision in the heat of the moment. When it comes to gathering information for making decisions, most of us rely on sources that reflect the consensus view. Yet the consensus, like Coyote, has a dismal record of spotting turns in the road ahead.

Prevailing wisdom on the economy is delivered to you by the news media, whose ratings depend on the excitement that extreme views generate. Politicians and business leaders with their own agendas contribute to the hype. The purveyors of this collective wisdom are focused on advancing their own interests, not yours. As with most things in life, ultimately you need to watch out for yourself.

An Objective Framework

As business cycle researchers, we use methods that set us apart from other economists. Our record validates our approach. We correctly forecasted major economic turning points in the United States and abroad over the past decades.6 While there is no Holy Grail in forecasting, the discipline and objectivity of our approach have allowed us to step away from the crowd at the right time and predict turning points when most forecasters fail (see Appendix A).

Economic forecasting deserves its bad reputation in predicting recessions and recoveries. As The Economist noted, "In March 2001, 95% of American economists thought there would not be a recession, yet one had already started."7 The reason for this failure is simple. Most economists forecast by extrapolating economic trends. While this methodology has its merits, forecasting turning points is not one of them.

Why does this approach fail to predict turning points? One key reason is that these forecasting models assume the recent past to be a good guide to the near future (see chart below). Most of the time this is true. But as we approach economic turning points, by definition, the pattern changes. The gap between such forecasts and reality balloons, resulting in large forecast errors.

Copyright © 2004 by Lakshman Achuthan and Anirvan Banerji.

About the Author

Lakshman Achuthan and Anirvan Banerji are the managing director and director of research at the famed Economic Cycle Research Institute. They are the trusted advisors of Fortune 500 companies, major fund managers, and government agencies throughout the world. They appear regularly on CNN's Moneyline, CNBC, and NPR, and have been featured in Money magazine and The Economist.