The Economy’s Four Horsemen

By Edward Harrison On Oct 15, 2008

Yesterday, I laid out some of my general thinking on the business cycle and the economy. Obviously, understanding the business cycle is important to economic forecasting and is, therefore, central to personal financial planning, general investing and business planning.

Over the next few weeks, I will chart out a panoply of data sets for the U.S. economy, which should give you a sense of where we are headed and how this compares to previous business cycles. But before I do, let me take this moment to give you a sense of how all of this ties in together.

The National Bureau of Economic Research (NBER) is the official arbiter of business cycles in the U.S. If you want to know when a recession occurs, it is the NBER which decides. The NBER relies on understanding four major economic data trends — the economy’s four horsemen:

How much we spend: retail sales
How much we earn: real earnings growth
How much we make: industrial production
How much we work: employment

But note, the NBER makes its analysis of these cycles to only determine when a business cycle peak has occurred and when a trough has occurred. Its recession call does not indicate when the rate of economic growth is slowing, which is the thing you want to know. Moreover, the NBER dates whether recession occurred only after the fact. That doesn’t do you much good if you are looking to act based upon where the economy is headed.

Never fear — there are ways to get to the bottom of all this. Joseph Ellis, in his book, “Ahead of the Curve,” does an amazing job of identifying cause and effect in the business cycle in a way that can be really helpful for anyone who wants to get a handle on where things are headed. Ellis was a Partner at Goldman Sachs and was ranked as the #1 industry analyst for eighteen consecutive years by Institutional Investor for the retail industry, a sector that desperately needs to know business cycle trends.

His basic findings bear repeating:

Cause and effect relationships and the sequence in which they occur are pretty consistent throughout history.

However, making sense of the data is complicated by two factors:
- 1. Reliance on recession as the key measure of economic difficulty. In fact, recession is a lagging indicator which is completely useless for planning purposes because most of the damage to the economy and your portfolio is done by the time recession hits. In the future, we need to look for reliable early signs of weakening economic activity if we want to avoid getting caught in the headlights of a recession.
  2. As I indicated in my post on retail sales, the business press and most pundits have an annoying habit of focusing on month-to-month and quarter-to-quarter data. Doing so misses the underlying relationships in the data.

Year-over-year rates of change are the critical factor. Don’t look at the absolute levels, focus in on the change — the delta, if you will.
Consumer spending makes up two-thirds of the economy and drives the rate of economic change more than any other variable. Therefore, predicting key turning points in consumer spending patterns is going to be critical. Ellis says doing this will generally also predict turning points in the economy as a whole. The sequence goes: consumers’ real hourly earnings to consumer spending to industrial production to capital spending to corporate profits.
Employment and business spending are lagging indicators and are not drivers of the business cycle at all. Companies cut investment in human and physical capital as a result of a slowdown in the rate of change in consumption.
In order to forecast uptrends and downtrends in specific sectors and regions, you will need to drill down into sector- or location-specific data.

So, as we move forward and I report out on the major economic trends, keep this framework in mind, because it will give you a sense of how things are connected. I will be very focused on retail sales, real earnings growth, industrial production and employment. I also highly recommend Ellis’ book to anyone looking to make forecasts whether for personal investment or business forecasting and spending.

Sources
Ahead of the Curve – Joseph Ellis