© CFA Institute. For candidate use only. Not for distribution.

Determining Market Structure 41

Monopoly markets and other situations in which companies have pricing power can
be inefficient because producers constrain output to cause an increase in prices.
Therefore, less of the good will be consumed, and it will be sold at a higher price,
which is generally inefficient for the overall market. As a result, many countries have
introduced competition law to regulate the degree of competition in many industries.
Market power in the real world is not always as clear as it is in textbook exam-
ples. Governments and regulators often have the difficult task of measuring market
power and establishing whether a firm has a dominant position that may resemble a
monopoly. A few historical examples of this are as follows:
1. In the 1990s, US regulators prosecuted agricultural corporation Archer
Daniels Midland for conspiring with Japanese competitors to fix the price of
lysine, an amino acid used as an animal feed additive. The antitrust action
resulted in a settlement that involved more than US$100 million in fines
paid by the cartel members.
2. In the 1970s, US antitrust authorities broke up the local telephone monop-
oly, leaving AT&T the long-distance business (and opening that business
to competitors), and required AT&T to divest itself of the local telephone
companies it owned. This antitrust decision brought competition, innova-
tion, and lower prices to the US telephone market.
3. European regulators (specifically, the European Commission) have affected
the mergers and monopoly positions of European corporations (as in the
case of the companies Roche, Rhone-Poulenc, and BASF, which were at the
center of a vitamin price-fixing case) as well as non-European companies
(such as Intel) that do business in Europe. Moreover, the merger between
the US company General Electric and the European company Honeywell
was denied by the European Commission on grounds of excessive market
concentration.
Quantifying excessive market concentration is difficult. Sometimes, regulators
need to measure whether something that has not yet occurred might generate exces-
sive market power. For example, a merger between two companies might allow the
combined company to be a monopolist or quasi-monopolist in a certain market.
A financial analyst hearing news about a possible merger should always consider
the impact of competition law (sometimes called antitrust law)—that is, whether a
proposed merger may be blocked by regulators in the interest of preserving a com-
petitive market.

Econometric Approaches
How should one measure market power? The theoretical answer is to estimate the
elasticity of demand and supply in a market. If demand is very elastic, the market
must be very close to perfect competition. If demand is rigid (inelastic), companies
may have market power.
From the econometric point of view, this estimation requires some attention.
The problem is that observed price and quantity are the equilibrium values of price
and quantity and do not represent the value of either supply or demand. Technically,
this is called the problem of endogeneity, in the sense that the equilibrium price and
quantity are jointly determined by the interaction of demand and supply. Therefore,
to have an appropriate estimation of demand and supply, we need to use a model with
two equations: an equation of demanded quantity (as a function of price, income of
the buyers, and other variables) and an equation of supplied quantity (as a function
of price, production costs, and other variables). The estimated parameters will then
allow us to compute elasticity.
 © CFA Institute. For candidate use only. Not for distribution.
42 Learning Module 1 The Firm and Market Structures

Regression analysis is useful in computing elasticity but requires a large number

of observations. Therefore, one may use a time-series approach and, for example,
look at 20 years of quarterly sales data for a market. The market structure may have
changed radically over those 20 years, however, and the estimated elasticity may not
apply to the current situation. Moreover, the supply curve may change because of a
merger among large competitors, and the estimation based on past data may not be
informative regarding the future state of the market postmerger.
An alternative approach is a cross-sectional regression analysis. Instead of looking
at total sales and average prices in a market over time (the time-series approach men-
tioned earlier), we can look at sales from different companies in the market during the
same year, or even at single transactions from many buyers and companies. Clearly,
this approach requires a substantial data-gathering effort, and therefore, this estima-
tion method can be complicated. Moreover, different specifications of the explanatory
variables (e.g., using total GDP rather than median household income or per-capita
GDP to represent income) may lead to dramatically different estimates.

Simpler Measures
Trying to avoid these drawbacks, analysts often use simpler measures to estimate
elasticity. The simplest measure is the concentration ratio, which is the sum of the
market shares of the largest N firms. To compute this ratio, one would, for example,
add the sales values of the largest 10 firms and divide this figure by total market sales.
This number is always between 0 (perfect competition) and 100 percent (monopoly).
The main advantage of the concentration ratio is that it is simple to compute, as
shown previously. The disadvantage is that it does not directly quantify market power.
In other words, is a high concentration ratio a clear signal of monopoly power? A
company may be the only incumbent in a market, but if the barriers to entry are low,
the simple presence of a potential entrant may be sufficient to convince the incumbent
to behave like a firm in perfect competition. For example, a sugar wholesaler may be
the only one in a country, but the knowledge that other large wholesalers in the food
industry might easily add imported sugar to their range of products should convince
the sugar wholesaler to price its product as if it were in perfect competition.
Another disadvantage of the concentration ratio is that it tends to be unaffected
by mergers among the top market incumbents. For example, if the largest and
second-largest incumbents merge, the pricing power of the combined entity is likely
to be larger than that of the two preexisting companies. But the concentration ratio
may not change much.

CALCULATING THE CONCENTRATION RATIO

Suppose there are eight producers of a certain good in a market. The largest
producer has 35 percent of the market, the second largest has 25 percent, the
third has 20 percent, the fourth has 10 percent, and the remaining four have 2.5
percent each. If we computed the concentration ratio of the top three producers,
it would be 35 + 25 + 20 = 80 percent, while the concentration ratio of the top
four producers would be 35 + 25 + 20 + 10 = 90 percent.
If the two largest companies merged, the new concentration ratio for the
top three producers would be 60 (the sum of the market shares of the merged
companies) + 20 + 10 = 90 percent, and the concentration ratio for the four top
producers would be 92.5 percent. Therefore, this merger affects the concentra-
tion ratio very mildly, even though it creates a substantial entity that controls
60 percent of the market.
 © CFA Institute. For candidate use only. Not for distribution.
Determining Market Structure 43

For example, the effect of consolidation in the US retail gasoline market has
resulted in increasing degrees of concentration. In 1992, the top four companies
in the US retail gasoline market shared 33 percent of the market. By 2001, the top
four companies controlled 78 percent of the market (Exxon Mobil 24 percent,
Shell 20 percent, BP/Amoco/Arco 18 percent, and Chevron/Texaco 16 percent).

To avoid the known issues with concentration ratios, economists O. C. Herfindahl

and A. O. Hirschman suggested an index in which the market shares of the top N
companies are first squared and then added. If one firm controls the whole market
(a monopoly), the Herfindahl–Hirschman index (HHI) equals 1. If there are M firms
in the industry with equal market shares, then the HHI equals (1/M). This provides a
useful gauge for interpreting an HHI. For example, an HHI of 0.20 would be analogous
to having the market shared equally by five firms.
The HHI for the top three companies in the example in the box above would be
0.352 + 0.252 + 0.202 = 0.225 before the merger, whereas after the merger, it would be
0.602 + 0.202 + 0.102 = 0.410, which is substantially higher than the initial 0.225. The
HHI is widely used by competition regulators; however, just like the concentration
ratio, the HHI does not take the possibility of entry into account, nor does it consider
the elasticity of demand. Therefore, the HHI has limited use for a financial analyst
trying to estimate the potential profitability of a company or group of companies.

EXAMPLE 4

The Herfindahl–Hirschman Index

1. Suppose a market has 10 suppliers, each of them with 10 percent of the

market. What are the concentration ratio and the HHI of the top four firms?
A. Concentration ratio 4 percent and HHI 40
B. Concentration ratio 40 percent and HHI 0.4
C. Concentration ratio 40 percent and HHI 0.04
Solution:
C is correct. The concentration ratio for the top four firms is 10 + 10 + 10 +
10 = 40 percent, and the HHI is 0.102 × 4 = 0.01 × 4 = 0.04.

QUESTION SET

1. An analyst gathers the following market share data for an industry:

​

Company Sales (in millions of euros)

ABC 300
Brown 250
Coral 200
Delta 150
Erie 100
All others 50
​

2. The industry’s four-company concentration ratio is closest to:

A. 71%.
 © CFA Institute. For candidate use only. Not for distribution.
44 Learning Module 1 The Firm and Market Structures

B. 86%.
C. 95%.
Solution:
B is correct. The top four companies in the industry account for 86 percent
of industry sales: (300 + 250 + 200 + 150)/(300 + 250 + 200 + 150 + 100 +
50) = 900/1050 = 86%.

The following information applies to questions 3 & 4

An analyst gathered the following market share data for an industry com-
posed of five companies:
​

Company Market Share (%)

Zeta 35
Yusef 25
Xenon 20
Waters 10
Vlastos 10
​

3. The industry’s three-firm Herfindahl–Hirschman index is closest to:

A. 0.185.
B. 0.225.
C. 0.235.
Solution:
B is correct. The three-firm Herfindahl–Hirschman index is 0.352 + 0.252 +
0.202 = 0.225.

4. One disadvantage of the Herfindahl–Hirschman index is that the index:

A. is difficult to compute.
B. fails to reflect low barriers to entry.
C. fails to reflect the effect of mergers in the industry.
Solution:
B is correct. The Herfindahl–Hirschman index does not reflect low barriers
to entry that may restrict the market power of companies currently in the
market.
 © CFA Institute. For candidate use only. Not for distribution.
Practice Problems 45

PRACTICE PROBLEMS
1. The short-term shutdown point of production for a firm operating under perfect
competition will most likely occur when:
A. price is equal to average total cost.

B. marginal revenue is equal to marginal cost.

C. marginal revenue is equal to average variable costs.

2. Under conditions of perfect competition, a company will break even when mar-
ket price is equal to the minimum point of the:
A. average total cost curve.

B. average variable cost curve.

C. short-run marginal cost curve.

3. A company will shut down production in the short run if total revenue is less
than total:
A. fixed costs.

B. variable costs.

C. opportunity costs.

4. A company has total variable costs of $4 million and fixed costs of $3 million.
Based on this information, the company will stay in the market in the long term if
total revenue is at least:
A. $3.0 million.

B. $4.5 million.

C. $7.0 million.

5. When total revenue is greater than total variable costs but less than total costs, in
the short term, a firm will most likely:
A. exit the market.

B. stay in the market.

C. shut down production.

6. Under conditions of perfect competition, in the long run, firms will most likely
earn:
A. normal profits.

B. positive economic profits.

C. negative economic profits.

7. A firm that increases its quantity produced without any change in per-unit cost is
 © CFA Institute. For candidate use only. Not for distribution.
46 Learning Module 1 The Firm and Market Structures

experiencing:
A. economies of scale.

B. diseconomies of scale.

C. constant returns to scale.

8. A company is experiencing economies of scale when:

A. cost per unit increases as output increases.

B. it is operating at a point on the LRAC curve at which the slope is negative.

C. it is operating beyond the minimum point on the long-run average total cost
curve.

9. Diseconomies of scale most likely result from:

A. specialization in the labor force.

B. overlap of business functions and product lines.

C. discounted prices on resources when buying in larger quantities.

10. A firm is operating beyond minimum efficient scale in a perfectly competitive

industry. To maintain long-term viability, the most likely course of action for the
firm is to:
A. operate at the current level of production.

B. increase its level of production to gain economies of scale.

C. decrease its level of production to the minimum point on the long-run aver-
age total cost curve.

11. Companies most likely have a well-defined supply function when the market
structure is:
A. oligopoly.

B. perfect competition.

C. monopolistic competition.

12. Aquarius, Inc. is the dominant company and the price leader in its market. One
of the other companies in the market attempts to gain market share by undercut-
ting the price set by Aquarius. The market share of Aquarius will most likely:
A. increase.

B. decrease.

C. stay the same.

13. Over time, the market share of the dominant company in an oligopolistic market
will most likely:
A. increase.

B. decrease.
 © CFA Institute. For candidate use only. Not for distribution.
Practice Problems 47

C. remain the same.

 © CFA Institute. For candidate use only. Not for distribution.
48 Learning Module 1 The Firm and Market Structures

SOLUTIONS
1. C is correct. The firm should shut down production when marginal revenue is
less than or equal to average variable cost.

2. A is correct. A company is said to break even if its total revenue is equal to its
total cost. Under conditions of perfect competition, a company will break even
when market price is equal to the minimum point of the average total cost curve.

3. B is correct. A company will shut down production in the short run when total
revenue is below total variable costs.

4. C is correct. A company will stay in the market in the long term if total revenue is
equal to or greater than total cost. Because total costs are $7 million ($4 million
variable costs and $3 million fixed costs), the company will stay in the market in
the long term if total revenue equals at least $7 million.

5. B is correct. When total revenue is enough to cover variable costs but not total
fixed costs in full, the firm can survive in the short run but would not be able to
maintain financial solvency in the long run.

6. A is correct. Competition should drive prices down to long-run marginal cost,

resulting in only normal profits being earned.

7. C is correct. Output increases in the same proportion as input increases occur at

constant returns to scale.

8. B is correct. Economies of scale occur if, as the firm increases output, cost per
unit of production falls. Graphically, this definition translates into an LRAC with
a negative slope.

9. B is correct. As the firm increases output, diseconomies of scale and higher av-
erage total costs can result when business functions and product lines overlap or
are duplicated.

10. C is correct. The firm operating at greater than long-run efficient scale is subject
to diseconomies of scale. It should plan to decrease its level of production.

11. B is correct. A company in a perfectly competitive market must accept whatever

price the market dictates. The marginal cost schedule of a company in a perfectly
competitive market determines its supply function.

12. A is correct. As prices decrease, smaller companies will leave the market rather
than sell below cost. The market share of Aquarius, the price leader, will increase.

13. B is correct. The dominant company’s market share tends to decrease as profits
attract entry by other companies.
 © CFA Institute. For candidate use only. Not for distribution.

LEARNING MODULE

2
Understanding Business Cycles
by Gambera Michele, PhD, CFA, Ezrati Milton, and Cao Bolong, PhD, CFA.
Michele Gambera, PhD, CFA, is with UBS Asset Management and the University of Illinois
at Urbana-Champaign (USA). Milton Ezrati (USA). Bolong Cao, PhD, CFA, is at Ohio
University (USA).

LEARNING OUTCOMES
Mastery The candidate should be able to:

describe the business cycle and its phases

describe credit cycles
describe how resource use, consumer and business activity, housing
sector activity, and external trade sector activity vary over the
business cycle and describe their measurement using economic
indicators

INTRODUCTION
A typical economy’s output of goods and services fluctuates around its long-term
1
path. We now turn our attention to those recurring, cyclical fluctuations in economic
output. Some of the factors that influence short-term changes in the economy—such
as changes in population, technology, and capital—are the same as those that affect
long-term sustainable economic growth. But forces that cause shifts in aggregate
demand and aggregate supply curves—such as expectations, political developments,
natural disasters, and fiscal and monetary policy decisions—also influence economies,
particularly in the short run.
We first describe a typical business cycle and its phases. While each cycle is dif-
ferent, analysts and investors need to be familiar with the typical cycle phases and
what they mean for the expectations and decisions of businesses and households
that influence the performance of sectors and companies. These behaviors also affect
financial conditions and risk appetite, thus affecting the setting of expectations and
choices of portfolio exposures to different investment sectors or styles.
In the lessons that follow, we describe credit cycles, introduce several theories
of business cycles, and explain how different economic schools of thought interpret
the business cycle and their recommendations with respect to it. We also discuss
 © CFA Institute. For candidate use only. Not for distribution.
50 Learning Module 2 Understanding Business Cycles

variables that demonstrate predictable relationships with the economy, focusing on

those whose movements have value in predicting the future course of the economy.
We then proceed to explain measures and features of unemployment and inflation.

LEARNING MODULE OVERVIEW

■ Business cycles are recurrent expansions and contractions in

economic activity affecting broad segments of the economy.
■ Classical cycle refers to fluctuations in the level of economic activity
(e.g., measured by GDP in volume terms).
■ Growth cycle refers to fluctuations in economic activity around the
long-term potential or trend growth level.
■ Growth rate cycle refers to fluctuations in the growth rate of economic
activity (e.g., GDP growth rate).
■ The overall business cycle can be split into four phases: recovery,
expansion, slowdown, and contraction.
■ In the recovery phase of the business cycle, the economy is going
through the “trough” of the cycle, where actual output is at its lowest
level relative to potential output.
■ In the expansion phase of the business cycle, output increases, and the
rate of growth is above average. Actual output rises above potential
output, and the economy enters the so-called boom phase.
■ In the slowdown phase of the business cycle, output reaches its highest
level relative to potential output (i.e., the largest positive output gap).
The growth rate begins to slow relative to potential output growth, and
the positive output gap begins to narrow.
■ In the contraction phase of the business cycle, actual economic output
falls below potential economic output.
■ Credit cycles describe the changing availability—and pricing—of
credit.
■ Strong peaks in credit cycles are closely associated with subsequent
systemic banking crises.
■ Economic indicators are variables that provide information on the
state of the overall economy.

● Leading economic indicators have turning points that usually

precede those of the overall economy.

● Coincident economic indicators have turning points that usually

are close to those of the overall economy.
● Lagging economic indicators have turning points that take place
later than those of the overall economy.
■ A diffusion index reflects the proportion of a composite index of
leading, lagging and coincident indicators that are moving in a pattern
consistent with the overall index. Analysts often rely on these diffusion
indexes to provide a measure of the breadth of the change in a com-
posite index.
 © CFA Institute. For candidate use only. Not for distribution.
Overview of the Business Cycle 51

OVERVIEW OF THE BUSINESS CYCLE

2
describe the business cycle and its phases

Business cycles are recurrent expansions and contractions in economic activity

affecting broad segments of the economy. In their 1946 book “Measuring Business
Cycles”, Burns and Mitchell define the business cycle as follows:
Business cycles are a type of fluctuation found in the aggregate economic
activity of nations that organize their work mainly in business enterprises:
a cycle consists of expansions occurring at about the same time in many
economic activities, followed by similarly general recessions, contractions,
and revivals which merge into the expansion phase of the next cycle; this
sequence of events is recurrent but not periodic; in duration, business
cycles vary from more than one year to 10 or 12 years.
This definition is rich with important insight. First, business cycles are typical of
economies that rely mainly on business enterprises—therefore, not agrarian societies
or centrally planned economies. Second, a cycle has an expected sequence of phases,
alternating between expansion and contraction, or upswings and downturns. Third,
such phases occur at about the same time throughout the economy. Finally, cycles are
recurrent; they happen again and again over time but not in a periodic way; they do
not all have the exact same intensity and duration. Exhibit 1 provides an illustration
of the pattern of economic growth rate in developed markets.

Exhibit 1: Fluctuations of Growth in OECD Countries over Time

Quarterly GDP (Y-o-y change %)
10

–2

–4

–6
1965 1972 1979 1986 1993 2000 2007 2014
Note: The Organisation for Economic Co-Operation and Development (OECD) includes more than
30 large member countries.
Source: OECD.Stat (https://​stats​.oecd​.org), year-over-year change in quarterly GDP in OECD
countries.

Burns and Mitchell’s definition remains helpful. History never repeats itself in quite
the same way, but it certainly does offer patterns that can be used when analyzing
the present and forecasting the future. Business cycle analysis is a wide-ranging topic
with conflicting perspectives held by industry participants.
 © CFA Institute. For candidate use only. Not for distribution.
52 Learning Module 2 Understanding Business Cycles

Phases of the Business Cycle

Business cycles are recurring sequences of alternating upswings and downturns. The
business cycle can be broken into phases in various ways. The most obvious way is to
divide it into two primary segments: the expansion, or the upswing, and the contrac-
tion, or the downturn, with two key turning points, or peaks and troughs (see Exhibits
2 and 3). These two periods are fairly easy to identify in retrospect. Subdividing the
cycle more finely, however, becomes ambiguous, even in retrospect, because it requires
identifying more nuanced changes, such as acceleration or deceleration of growth
without a change in its direction. It thus is useful to divide the cycle into several phases
distinguished through both economic and financial market characteristics. Our focus
is on economic characteristics of the different phases, but we also will highlight their
implication for the behavior of different segments of the financial markets.
The timing of these periods will depend on the type of cycle. Before moving on
to the description of the four distinct phases to which we will refer in the subsequent
sections, we first explain the different cycle concepts that analysts should be aware
of given the range of different opinions, interpretations, and descriptions that prac-
titioners use.

Types of Cycles

■ Classical cycle refers to fluctuations in the level of economic activity (e.g.,

measured by GDP in volume terms). The contraction phases between peaks
and troughs are often short, whereas expansion phases are much longer.
Exhibit 2 shows the classical cycle of economic activity. In practice, the clas-
sical cycle is not used extensively by academics and practitioners because it
does not easily allow the breakdown of movements in GDP between short-
term fluctuations and long-run trends. In addition, an absolute decline in
activity between peaks and troughs does not occur frequently.

Exhibit 2: Classical Cycle

Index
115
Classical Cycle: Expansion Peak
Classical Cycle:
110 Contraction
Trough
105

100 Peak Trough

95

Output (left scale)

■ Growth cycle refers to fluctuations in economic activity around the

long-term potential or trend growth level. The focus is on how much actual
economic activity is below or above trend growth in economic activity. The
dashed “wave” in the lower part of Exhibit 3 captures the fluctuation of
actual activity from trend growth activity. Exhibit 3 shows “gaps” between
actual and trend output. The growth cycle definition comes closest to how
mainstream economists think: It dissects overall economic activity into a
 © CFA Institute. For candidate use only. Not for distribution.
Overview of the Business Cycle 53

part driven by long-run trends and a part reflecting short-run fluctuations.

Compared with the classical view of business cycles, peaks generally are
reached earlier and troughs later in time. The time periods below and above
trend growth are of similar length.

Exhibit 3: Classical and Growth Cycles

Index Deviation (in %)
115
Classical Cycle: Expansion Peak
110 Classical Cycle:
Contraction Trend GDP
Trough
105 Growth cycle trough
Growth cycle peak
corresponds to the corresponds to the
Trough largest negative gap
100 Peak largest positive gap 4
between actual between actual GDP
GDP and trend Peak and trend GDP
95 2
GDP

0
Trough Trough
–2

Output (left scale) Potential Output (left scale)

Growth Cycle (right scale)

■ Growth rate cycle refers to fluctuations in the growth rate of economic

activity (e.g., GDP growth rate). Peaks and troughs are mostly recognized
earlier than when using the other two definitions (see Exhibit 4). One
advantage of this approach is that it is not necessary to first estimate a
long-run growth path. Nevertheless, economists often refer to economic
growth being above or below potential growth rate, reflecting upswings or
downturns.

Exhibit 4: Classical, Growth, and Growth Rate Cycles

Index Deviation (in %)
115
Classical Cycle: Expansion
110 Classical Cycle:
Contraction Highest
rate of
105 Highest Lowest growth
rate of rate of
Trough growth growth
100 Peak Peak Peak 4

95 2

0
Trough
Trough
–2

Output (left scale) Potential Output (left scale)

Growth Cycle (right scale) Growth Rate Cycle (right scale)
Potential Output (right scale)

Notes: The vertical lines indicate troughs and peaks when using either the classical, growth, or
growth rate cycle definition of a business cycle. The growth cycle reflects the percentage deviation
of output relative to its trend. The growth rates in the growth rate cycle are calculated as annualized
month-over-month growth rates.
 © CFA Institute. For candidate use only. Not for distribution.
54 Learning Module 2 Understanding Business Cycles

Practical Issues
In practice, the definitions of a business cycle are used interchangeably, which often
causes confusion regarding how one labels the phases and their timing. The classical
cycle definition is rarely used. In line with how most economists and practitioners
view the cycle, we will generally be using the growth cycle concept in which business
cycles can be thought of as fluctuations around potential output (the trend in potential
output is shown as the upward sloping dotted line in Exhibit 3).

Four Phases of the Cycle

The overall business cycle can be split into four phases:
Recovery: The economy is going through the “trough” of the cycle, where actual
output is at its lowest level relative to potential output. Economic activity, including
consumer and business spending, is below potential but is starting to increase, closing
the negative output gap.
Expansion: The recovery gathers pace, output increases, and the rate of growth is
above average. Actual output rises above potential output, and the economy enters the
so-called boom phase. Consumers increase spending, and companies increase pro-
duction, employment, and investment. Prices and interest rates may start increasing.
As the expansion continues, the economy may start to experience shortages in factors
of production. Overinvestment in productive capacity may lead companies to reduce
further investment spending.
Slowdown: Output of the economy reaches its highest level relative to potential
output (largest positive output gap). The growth rate begins to slow relative to poten-
tial output growth, and the positive output gap begins to narrow. Consumers remain
optimistic about the economy, but companies may rely on overtime rather than using
new hires to meet demand. Inflation slows at some point, and price levels may decrease.
Contraction: Actual economic output falls below potential economic output.
Consumer and business confidence declines. Companies reduce costs by eliminating
overtime and reducing employment. The economy may experience declines in absolute
economic activity; a recession; or if the fall in activity is particularly large, a depression.
If the decline is moderate, this phase tends to be shorter than the expansion phase.
Exhibit 5 provides a summary of the key characteristics of each phase and describes
how several important economic variables evolve through the course of a business cycle.

Exhibit 5: Business Cycle Phase Characteristics

Gap between
actual GDP
and trend GDP
Peak

Time

Trough Trough

Recovery Expansion Slowdown Contraction

 © CFA Institute. For candidate use only. Not for distribution.
Overview of the Business Cycle 55

Phase Recovery Expansion Slowdown Contraction

Description Economy going through Economy enjoying an Economy going through Economy weakens and
a trough. Negative upswing. Positive out- a peak. Positive output may go into a recession.
output gap starts to put gap opens. gap starts to narrow. Negative output gap
narrow. opens.
Activity levels: Activity levels are below Activity measures show Activity measures are Activity measures are
consumers and potential but start to above-average growth above average but below potential. Growth
businesses increase. rates. decelerating. Moving to is lower than normal.
below-average rates of
growth.
Employment Layoffs slow. Businesses Businesses move from Business continue hir- Businesses first cut
rely on overtime before using overtime and ing but at a slower pace. hours, eliminate over-
moving to hiring. temporary employees to Unemployment rate time, and freeze hiring,
Unemployment remains hiring. Unemployment continues to fall but at followed by outright
higher than average. rate stabilizes and starts decreasing rates. layoffs. Unemployment
falling. rate starts to rise.
Inflation Inflation remains Inflation picks up Inflation further Inflation decelerates but
moderate. modestly. accelerates. with a lag.

Leads and Lags in Business and Consumer Decision Making

The behavior of businesses and households is key to the cycle and frequently incorpo-
rates leads and lags relative to what are established as turning points. For example, at
the beginning of an expansion phase, companies may want to fully use their existing
workforce and wait to hire new employees until they are sure that the economy is
indeed growing. However, gradually all economic variables are going to revert toward
their normal range of values (e.g., GDP growth will be close to potential, or average,
growth).

Market Conditions and Investor Behavior

Many economic variables and sectors of the economy have distinctive cyclical patterns.
Knowledge of these patterns can offer insight into likely cyclical directions overall, or
it can be particularly applicable to an investment strategy that requires more specific
rather than general cyclical insights for investment success.

Recovery Phase
When asset markets expect the end of a recession and the beginning of an expansion
phase, risky assets will be repriced upward. When an expansion is expected, the markets
will start incorporating higher profit expectations into the prices of corporate bonds
and stocks. Typically, equity markets will hit a trough about three to six months before
the economy bottoms out and well before the economic indicators turn up. Indeed, as
we will see later, the equity market is classified as a leading indicator of the economy.

Expansion Phase
When an economy’s expansion is well-established, a later part of an expansion, referred
to as a “boom,” often follows. The boom is an expansionary phase characterized by
economic growth “testing the limits” of the economy, strong confidence, profit, and
credit growth. For example, companies may expand so much that they have difficulty
finding qualified workers and will compete with other prospective employers by
 © CFA Institute. For candidate use only. Not for distribution.
56 Learning Module 2 Understanding Business Cycles

raising wages and continuing to expand capacity, relying on strong cash flows and
borrowing. The government or central bank may step in if it is concerned about the
economy overheating.

Slowdown Phase
During the boom, the riskiest assets will often have substantial price increases. Safe
assets, such as government bonds that were more highly prized during recession,
may have lower prices and thus higher yields. In addition, investors may fear higher
inflation, which also contributes to higher nominal yields.

Contraction Phase
During contraction, investors place relatively high values on such safer assets as
government securities and shares of companies with steady (or growing) positive
cash flows, such as utilities and producers of staple goods. Such preferences reflect
the fact that the marginal utility of a safe income stream increases in periods when
employment is insecure or declining.

WHEN DO RECESSIONS BEGIN AND END?

A simple and commonly referred to rule is the following: A recession has started
when a country or region experiences two consecutive quarters of negative real
GDP growth. Real GDP growth is a measure of the “real” or “inflation-adjusted”
growth of the overall economy. This rule can be misleading because it does not
indicate a recession if real GDP growth is negative in one quarter, slightly positive
the next quarter, and again negative in the next quarter. Many analysts question
this result. This issue is why some countries have statistical and economic com-
mittees that apply the principles stated by Burns and Mitchell to several macro-
economic variables—not just real GDP growth—as a basis to identify business
cycle peaks and troughs. The National Bureau of Economic Research (NBER)
is an organization that dates business cycles in the United States. Interestingly,
the economists and statisticians on NBER’s Business Cycle Dating Committee
analyze numerous time series of data focusing on employment, industrial
production, and sales. Because the data are available with a delay (preliminary
data releases can be revised even several years after the period they refer to), it
also means that the Committee’s determinations may take place well after the
business cycle turning points have occurred. As we will see later in the reading,
practical indicators may help economists understand in advance if a cyclical
turning point is about to happen.

1. Which of the following rules is most likely to be used to determine whether

the economy is in a recession?
A. The central bank has run out of foreign reserves.
B. Real GDP has two consecutive quarters of negative growth.
C. Economic activity experiences a significant decline in two business
sectors.
Solution:
B is correct. GDP is a measure of economic activity for the whole economy.
Changes in foreign reserves or a limited number of sectors may not have a
material impact on the whole economy.

2. Suppose you are interested in forecasting earnings growth for a company

active in a country where no official business cycle dating committee (such
 © CFA Institute. For candidate use only. Not for distribution.
Credit Cycles 57

as the NBER) exists. The variables you are most likely to consider to identify
peaks and troughs of a country’s business cycle are:
A. inflation, interest rates, and unemployment.
B. stock market values and money supply.
C. unemployment, GDP growth, industrial production, and inflation.
Solution:
C is correct. Unemployment, GDP growth, industrial production, and
inflation are measures of economic activity. The discount rate, the mone-
tary base, and stock market indexes are not direct measures of economic
activities. The first two are determined by monetary policy, which react to
economic activities, whereas the stock market indexes tend to be forward
looking or leading indicators of the economy.

QUESTION SET

1. The characteristic business cycle patterns of trough, expansion,

peak, and contraction are:
A. periodic.
B. recurrent.
C. of similar duration.
Solution:
B is correct. The stages of the business cycle occur repeatedly over time.

2. During the contraction phase of a business cycle, it is most likely that:

A. inflation indicators are stable.
B. aggregate economic activity relative to potential output is decreasing.
C. investor preference for government securities declines.
Solution:
B is correct. The net trend during contraction is negative.

3. An economic peak is most closely associated with:

A. accelerating inflation.
B. stable unemployment.
C. declining capital spending.
Solution:
A is correct. Inflation is rising at peaks.

CREDIT CYCLES
3
describe credit cycles
 © CFA Institute. For candidate use only. Not for distribution.
58 Learning Module 2 Understanding Business Cycles

Whereas business cycles mostly use GDP as a measure of economic activity, a body
of literature has emerged in which cyclical developments of financial variables are
analyzed separately. This is most commonly done in terms of credit and property
prices. Credit cycles describe the changing availability—and pricing—of credit. They
describe growth in private sector credit (availability and usage of loans), which is
essential for business investments and household purchases of real estate. Therefore,
they are connected to real economic activity captured by business cycles that describe
fluctuations in real GDP.
When the economy is strong or improving, the willingness of lenders to extend
credit, and on favorable terms, is high. Conversely, when the economy is weak or
weakening, lenders pull back, or “tighten” credit, by making it less available and
more expensive. This frequently contributes to the decline of such asset values as real
estate, causing further economic weakness and higher defaults. This is because of the
importance of credit in the financing of construction and the purchase of property.
Credit cycles are a subset of a wider family of so-called financial cycles, a topic that
goes beyond the scope of our coverage.

Applications of Credit Cycles

Financial factors were for a long time not prominent on the radar screens of macro-
economists. Monetary and financial phenomena were largely seen as a veil that could
be ignored when trying to understand the economy. But loose private sector credit
is considered to have contributed to several financial crises, such as the Latam crisis
of the 1980s; the Mexican, Brazilian, and Russian crises of the 1990s; the Asian crisis
of 1997–1998; and the Global Financial Crisis of 2008–2009. Expansive credit condi-
tions often lead to asset price and real estate bubbles that burst when capital market
outflows and drawdowns occur mostly because of weaker fundamentals.
It is recognized that in a world with financial frictions, business cycles can be
amplified, with deeper recessions and more extensive expansions because of changes
in access to external financing. In line with this belief, it is found that the duration
and magnitude of recessions and recoveries are often shaped by linkages between
business and credit cycles. In particular, recessions accompanied by financial disrup-
tion episodes (notably, house and equity price busts), tend to be longer and deeper.
Recoveries combined with rapid growth in credit, risk-taking, and house prices tend
to be stronger.
Financial variables tend to co-vary closely with each other and can often help
explain the size of an economic expansion or contraction, but they are not always syn-
chronized with the traditional business cycle. Credit cycles tend to be longer, deeper,
and sharper than business cycles. Although the length of a business cycle varies from
peak to trough, the average length of a credit cycle is mostly found to be longer than
that of the business cycle. Exhibit 6 illustrates how credit cycles can be visualized.

VISUALIZING FINANCIAL CYCLES

In an October 2019 working paper titled “Predicting Recessions: Financial Cycle

versus Term Spread,” the Bank for International Settlements (BIS) provided a
visual presentation of credit cycles, which is reproduced in Exhibit 6. It shows
that such cycles tend to boom before recessions.
 © CFA Institute. For candidate use only. Not for distribution.
Credit Cycles 59

Exhibit 6: BIS Visualization of Financial Cycles

​

Financial cycles tend to boom ahead of recessions 1 Graph 1

United States United Kingdom

0.12 0.2

0.06 0.1

0.00 0.0

–0.06 –0.1

–0.12 –0.2
87 92 97 02 07 12 17 87 92 97 02 07 12 17
The shaded areas represent recessions.
1
Financial cycles are measured by the composite financial cycle proxy calculated from frequency-based (bandpass) filters capturing medium-
term cycles in real credit, the credit-to-GDP ratio and real house prices.

Notes: Credit cycles are measured by a (composite) proxy calculated from variables that include
credit-to-GDP ratio and real house prices. The axis on the right shows the year-on-year change
in the proxy.

Source: Bank for International Settlement (BIS) Material (available on the BIS website: www​.bis​
.org).

Consequences for Policy

Investors pay attention to the stage in the credit cycle because (1) it helps them
understand developments in the housing and construction markets; (2) it helps them
assess the extent of business cycle expansions as well as contractions, particularly the
severity of a recession if it coincides with the contraction phase of the credit cycle;
and (3) it helps them better anticipate policy makers’ actions. Whereas monetary and
fiscal policy traditionally concentrate on reducing the volatility of business cycles,
macroprudential stabilization policies that aim to dampen financial booms have gained
importance. This is further stressed by findings that strong peaks in credit cycles are
closely associated with subsequent systemic banking crises.

QUESTION SET

1. A senior portfolio manager at Carnara Asset Management explains

her analysis of business cycles to a junior analyst. She makes two statements:

Statement 1 Business cycles measure activity by GDP, whereas credit cycles

combine a range of financial variables, such as the amount of
and pricing of credit.
Statement 2 Credit cycles and business cycles are unrelated and serve differ-
ent purposes.
A. Only Statement 1 is true.
B. Only Statement 2 is true.
C. Both statements are true.
Solution:
A is correct. Only Statement 1 is true. Statement 2 is not true because
researchers have found linkages between financial and business cycles that
help explain the magnitude of business cycle expansions and contractions
depending on the state of the credit cycle.
 © CFA Institute. For candidate use only. Not for distribution.
60 Learning Module 2 Understanding Business Cycles

2. With which sector of the economy would analysts most commonly associate
credit cycles?
A. Exports
B. Construction and purchases of property
C. Food retail
Solution:
B is correct. Credit cycles are associated with availability of credit, which is
important in the financing of construction and the purchase of property.

3. The reason analysts follow developments in the availability of credit is that:

A. loose private sector credit may contribute to the extent of asset price
and real estate bubbles and subsequent crises.
B. loose credit helps reduce the extent of asset price and real estate
bubbles.
C. credit cycles are of same length and depth as business cycles.
Solution:
A is correct. Studies have shown that loose credit conditions contribute to
the extent of asset price and real estate bubbles that tend to be followed by
crises.

4 ECONOMIC INDICATORS OVER THE BUSINESS CYCLE

describe how resource use, consumer and business activity, housing

sector activity, and external trade sector activity vary over the
business cycle and describe their measurement using economic
indicators

This lesson provides a broad overview of how the use of resources needed to produce
goods and services typically evolves during a business cycle. We start by focusing on
circumstances of firms and explore some of the links between fluctuations in inven-
tory, employment, and investment in physical capital with economic fluctuations.

The Workforce and Company Costs

The pattern of hiring and employment is shown in Exhibit 7 . When the economy
enters contraction, companies reduce costs and eliminate overtime. They may try to
retain workers rather than reduce employment only to increase it later. Finding and
training new workers is costly, and it may be more cost efficient to keep workers on
the payroll even if they are not fully utilized. Companies may also benefit from an
implicit bond of loyalty between a company and its workers, boosting productivity
in the process. In prolonged contractions, companies will start reducing costs more
aggressively—terminating consultants, advertising campaigns, and workers beyond
the strict minimum. Capacity utilization will be low, and few companies will invest in
new equipment. Companies will try to liquidate their inventories of unsold products.
In addition, banks will be reluctant to lend because bankruptcy risks are perceived to
be higher, adding to the weakness in the economy.
 © CFA Institute. For candidate use only. Not for distribution.
Economic Indicators over the Business Cycle 61

Decreases in aggregate demand are likely to depress wages or wage growth as

well as prices of inputs and capital goods. After a while, all of these input prices will
be relatively low. In addition, interest rates may be cut to try to revive the economy.
As prices and interest rates decrease, consumers and companies may begin to
purchase more and aggregate demand may begin to rise. This stage is the turning
point of the business cycle: Aggregate demand starts to increase and economic activity
increases.

Exhibit 7: Business Cycle Phases—Levels of Employment

Gap between
actual GDP
and trend GDP
Peak

Time

Trough Trough

Recovery Expansion Slowdown Contraction

Phase Recovery Expansion Slowdown Contraction

Description of Economy starts at trough Economy enjoys an Economy at peak. Economy goes into a
activity levels and output below poten- upswing, with activ- Activity above average contraction, (recession, if
tial. Activity picks up, ity measures showing but decelerating. The severe). Activity mea-
and gap starts to close. above-average growth economy may experience sures are below potential.
rates. shortages of factors of Growth is lower than
production as demand normal.
may exceed supply.
Employment Layoffs slow. Businesses Businesses move from Businesses continue hir- Businesses first cut hours,
rely on overtime before using overtime and ing but at a slower pace. eliminate overtime, and
moving to hiring. temporary employees to Unemployment rate freeze hiring, followed
Unemployment remains hiring. Unemployment continues to fall but at by outright layoffs.
higher than average. rate stabilizes and starts slowly decreasing rates. Unemployment rate starts
falling. to rise.
Levels of employment lag the cycle

Fluctuations in Capital Spending

Capital spending—spending on tangible goods, such as property, plant, and equipment—
typically fluctuates with the business cycle. Because business profits and cash flows
are sensitive to changes in economic activity, capital spending is also highly sensitive
to changes in economic activity. In fact, investment is one of the most procyclical
and volatile components of GDP. Company spending decisions are driven by busi-
ness conditions, expectations, and levels of capacity utilization, all of which fluctuate
over the cycle. With regard to efficiency, firms will run “lean production” to generate
maximum output with the fewest number of workers at the end of contractions.
Exhibit 8 provides a description of capital spending over the cycle. Note that new
orders statistics include orders that will be delivered over several years. For example,
 © CFA Institute. For candidate use only. Not for distribution.
62 Learning Module 2 Understanding Business Cycles

it is common for airlines to order 40 airplanes to be delivered over five years. Where
relevant, analysts use “core” orders that exclude defense and aircrafts for a better
understanding of the economy’s trend.

Exhibit 8: Capital Spending during the Economic Cycle

Business conditions and

Phase of the Cycle expectations Capital spending Examples

Recovery Excess capacity during trough, Low but increasing as compa- Software, systems, and hardware
low utilization, little need for nies start to enjoy better condi- (high rates of obsolescence) orders
capacity expansion. tions. Capex focus on efficiency placed or re-instated first.
Interest rates tend to be low— rather than capacity.
supporting investment. Upturn most pronounced in
orders for light producer equip-
ment.
Typically, the orders initially
reinstated are for equipment
with a high rate of obso-
lescence, such as software,
systems, and technological
hardware.
Expansion Companies enjoy favorable con- Customer orders and capacity Heavy and complex equipment,
ditions. utilization increase. Companies warehouses, and factories.
Capacity utilization increases start to focus on capacity A company may need warehouse
from low levels. Over time, expansion. space in locations different from
productive capacity may begin The composition of the econo- where existing facilities are located.
to limit ability to respond to my’s capacity may not be opti-
demand. mal for the current structure of
Growth in earnings and cash flow demand, necessitating spending
gives businesses the financial on new types of equipment.
ability to increase investment Orders precede actual ship-
spending. ments, so orders for capital
equipment are a widely watched
indicator of the future direction
of capital spending.
Slowdown Business conditions at peak, with New orders intended to Fiber-optic overinvestment in
healthy cash flow. increase capacity may be an the late 1990s that peaked with
Interest rates tend to be higher— early indicator of the late stage the “technology, media, telecoms
aimed at reducing overheating of the expansion phase. bubble.”
and encouraging investment Companies continue to place
slowdown. new orders as they operate at or
near capacity.
Contraction Companies experience fall in New orders halted, and some Technology and light equipment
demand, profits, and cash flows. existing orders canceled (no with short lead times get cut first.
need to expand). Cuts in construction and heavy
Initial cutbacks may be sharp equipment follow.
and exaggerate the economy’s
downturn. As the general cycli-
cal bust matures, cutbacks in
spending on heavy equipment
further intensify the contrac-
tion. Maintenance scaled back.
 © CFA Institute. For candidate use only. Not for distribution.
Economic Indicators over the Business Cycle 63

EXAMPLE 1

Capital Spending

1. Levels of capacity utilization are one of the factors that determine compa-
nies’ aggregate need for additional capital expenditure. Which of the follow-
ing is another factor that affects the capital expenditure decision?
A. The rate of unemployment
B. The composition of the economy’s capacity in relation to how it can
satisfy demand
C. The ability to reinstate orders canceled during the contraction stage
Solution:
B is correct. The composition of the current productive capacity may not be
optimal of the current structure of demand. C is incorrect because the abili-
ty to re-instate canceled orders is a matter that is relevant once the decision
to increase capital expenditure is made.

2. Orders for technology and light equipment decline before construction

projects in a contraction because:
A. businesses are uncertain about cyclical directions.
B. equipment orders are easier to cancel than large construction projects.
C. businesses value light equipment less than structures and heavy
machinery.
Solution:
B is correct. Because it usually takes much longer to plan and complete large
construction projects than it takes to plan and complete equipment orders,
construction projects may be less influenced by business cycles.

Fluctuations in Inventory Levels

The aggregate size of inventories is small relative to the size of the economy, but
their accumulation and cutbacks by businesses can occur with substantial speed and
frequency. Changing inventories reflect differences between the growth (or decline)
in sales and the growth (or decline) in production. A key indicator in this area is the
inventory–sales ratio that measures the inventories available for sale to the level of
sales. Analysts pay attention to inventories to gauge the position of the economy
in the cycle. Exhibit 9 shows how production, sales, and inventories typically move
through the phases of a cycle.
 © CFA Institute. For candidate use only. Not for distribution.
64 Learning Module 2 Understanding Business Cycles

Exhibit 9: Inventories throughout the Cycle

Phase of
the Cycle Recovery Expansion Slowdown Contraction

Sales and Decline in sales slows. Sales increase. Production Sales slow faster than Businesses produce at
production Sales subsequently recover. rises fast to keep up with sales production; inventories rates below the sales
Production upturn follows growth and to replenish inven- increase. volumes necessary to
but lags behind sales growth. tories of finished products. Economic slowdown dispose of unwanted
Over time, production This increases the demand leads to production inventories.
approaches normal levels as for intermediate products. cutbacks and order
excess inventories from the “Inventory rebuilding or cancellations.
downturn are cleared. restocking stage.”
Inventory– Begins to fall as sales recov- Ratio stable. Ratio increases. Signals Ratio begins to fall
sales ratio ery outpaces production. weakening economy. back to normal.

EXAMPLE 2

Inventory Fluctuation

1. Although a small part of the overall economy, changes in inventories can

influence economic growth measures significantly because they:
A. reflect general business sentiment.
B. tend to move forcefully up or down.
C. determine the availability of goods for sale.
Solution:
B is correct. Inventory levels can fluctuate dramatically over the business
cycle.

2. Inventories tend to rise when:

A. inventory–sales ratios are low.
B. inventory–sales ratios are high.
C. economic activity begins to rebound.
Solution:
A is correct. When the economy starts to recover, sales of inventories can
outpace production, which results in low inventory–sales ratios. Companies
then need to accumulate more inventories to restore the ratio to normal
level. C is incorrect because in the early stages of a recovery, inventories are
likely to fall as sales increase faster than production.

3. Inventories will often fall early in a recovery because:

A. businesses need profit.
B. sales outstrip production.
C. businesses ramp up production because of increased economic
activity.
Solution:
B is correct. The companies are slow to increase production in the early
recovery phase because they first want to confirm the recession is over. In-
creasing output also takes time after the downsizing during the recession.
 © CFA Institute. For candidate use only. Not for distribution.
Economic Indicators over the Business Cycle 65

4. In a recession, companies are most likely to adjust their stock of physical

capital by:
A. selling it at fire sale prices.
B. not maintaining equipment.
C. quickly canceling orders for new construction equipment.
B is correct. Physical capital adjustments to downturns come through aging
of equipment plus lack of maintenance.

5. The inventory–sales ratio is most likely to be rising:

A. as a contraction unfolds.
B. partially into a recovery.
C. near the top of an economic cycle.
C is correct. Near the top of a cycle, sales begin to slow before production is
cut, leading to an increase in inventories relative to sales.

Economic Indicators
Economic indicators are variables that provide information on the state of the overall
economy. They are statistics or data readings that reflect economic circumstances of a
country, group of countries, region, or sector. Economic indicators are used by policy
makers and analysts to understand and assess the existing condition of the economy and
its position in the cycle. They also can be used to help predict or confirm the turning
points in the cycle. Such knowledge allows analysts to better predict the financial and
market performance of stocks and bonds of issuers operating in different sectors of
the economy with different sensitivity to the economic cycle.

Types of Indicators
Economic indicators are often classified according to whether they lag, lead, or coin-
cide with changes in an economy’s growth.
■ Leading economic indicators have turning points that usually precede
those of the overall economy. They are believed to have value for predicting
the economy’s future state, usually near term.
■ Coincident economic indicators have turning points that are usually close
to those of the overall economy. They are believed to have value for identify-
ing the economy’s present state.
■ Lagging economic indicators have turning points that take place later than
those of the overall economy. They are believed to have value in identify-
ing the economy’s past condition and only change after a trend has been
established.
Exhibit 10 provides an illustration of several leading, lagging, and coincident indi-
cators. The leading indicators observed at a point in time labeled as time “1” indicate
the direction of the of the activity (output) at a future point in time, such as time “2.”
The lagging indicators, released around time “3,” refer to and help confirm what the
state of the economy was at time “2.”
 © CFA Institute. For candidate use only. Not for distribution.
66 Learning Module 2 Understanding Business Cycles

Exhibit 10: Types of Economic Indicators

Industrial production
refects the current state
better than services
Level of Leading indicators*: Coincident indicators:
economic • Stock market • Industrial production index
activity • House prices • Real personal incomes
• Retail sales • Manufacturing and trade sales
• Interest spread
(between LT and ST
rates) Businesses wait to see that
• Building permits upturn or downturn is
• Consumer expectations confirmed before changing
• Average weekly hours employment
(manufacturing)
• Manufacturers’ new Accumulate at the
orders Lagging indicators: peak and deplete
• Avg. duration of unemployment when sales pick up
• Inventory to sales ratio
• Change in unit labor costs Adjusts slower as index
• Inflation includes more stable
• Average prime lending rate services component
• Ratio of consumer instalment
debt to income
• Commercial and industrial Consumers only
loans outstanding loans borrow heavily when
confident – lags during
upturn but debt stays
1 2 3 into downturns
Time
Frequently support inventory
building, lagging the cycle

* Leading indicators will be explored in the subsequent section.

Composite Indicators
An economic indicator either consists of a single variable, like industrial production
or the total value of outstanding building permits, or can be a composite of different
variables that all tend to move together. The latter are regularly labeled composite
indicators. Traditionally, most composite indicators to measure the cyclical state of
the economy consist of up to a dozen handpicked variables published by organizations
like the OECD or national research institutes. The exact variables combined into these
composites vary from one economy to the other. In each case, however, they bring
together various economic and financial measures that have displayed a consistently
leading, coincident, or lagging relationship to that economy’s general cycle.

Leading Indicators
The Conference Board, a US industry research organization, publishes a composite
leading indicator known as The Conference Board Leading Economic Index (LEI),
which consists of 10 component parts (it uses the classical business cycle as the under-
lying concept). Exhibit 11 presents the 10 components used in the LEI. In addition to
naming the indicators, it offers a general description of why each measure is leading
the business cycle.
 © CFA Institute. For candidate use only. Not for distribution.
Economic Indicators over the Business Cycle 67

Exhibit 11: Index of Leading Economic Indicators, United States

Leading indicators Reason for use
Average weekly hours, Businesses will cut overtime before laying off
manufacturing workers in a downturn and increase it before
rehiring in a cyclical upturn. Moves up and down
before the general economy.
Average weekly initial claims A very sensitive test of initial layoffs and
for unemployment insurance rehiring.
Manufacturers’ new orders Businesses cannot wait too long to meet demand
for consumer goods and without ordering. Orders tend to lead at upturns
materials and downturns & captures business sentiment.

The Institute of Supply Management (ISM)

polls its members to build indexes of
manufacturing orders, output, employment,
pricing, and comparable gauges for services.

A diffusion index usually measures the percentage of components in a series

that are rising in the same period. It indicates how widespread a particular
ISM new order
movement in the trend is among the individual components.
index
Reflects the month on month change in new orders
Survey based
for final sales. Decline of new orders can signal weak
demand and can lead to recession.
Manufacturers’ new orders Captures business expectations and offers first
for non-defense capital signal of movement up or down. Important sector.
goods excluding aircraft
Building permits for new Signals new construction activity as permits required
private housing units before new building can begin.
S&P 500 Index Stocks tends to anticipate economic turning points;
useful early signal.
Leading Credit Index A vulnerable financial system can amplify the effects
of negative shocks, causing widespread recessions.
Aggregates the
information from six
leading financial
indicators, which reflect
the strength of the
Interest rate financial system to LT (10 or 30 year) bond yields express market
spread between endure stress. expectations about the direction of short-term
10-year treasury interest rates. As rates ultimately follow the
yields and economic cycle up and down, a wider spread, by
overnight anticipating short rate increases, also anticipates
borrowing rates Inversion of the an economic upswing and vice versa.
(federal funds yield curve occurs
rate) when ST interest
rate exceed LT rates
– meaning that ST
rates are expected
to fall and activity is
expected to weaken.

Average consumer Optimism tends to increase spending. Provides

expectations for Survey based early insight into the direction ahead for the whole
business conditions economy.

Using Economic Indicators

Exhibit 12 shows a simplified process that an analyst could use to identify business cycle
phases. The conclusions then can be used to make investment decisions—for exam-
ple, to decide in what sectors companies are likely to see improving or deteriorating
 © CFA Institute. For candidate use only. Not for distribution.
68 Learning Module 2 Understanding Business Cycles

cash flows, which could affect the investment performance of the equity and debt
securities issued by the companies. Note that the order of the steps does not have to
follow this particular sequence.

Exhibit 12: Use of Statistics to Identify Business Cycle Phase

Step 1
● Data release: Analyst notes an increase in the reported level of con-
sumer instalment debt to income.
● Analysis: The above indicator normally lags cyclical upturns.
● Possible conclusion: Initial evidence that an upturn has been
underway.
Step 2
● Data release: Industrial Production Index and non-farm payrolls
(employees on non-agricultural payrolls) are moving higher.
● Analysis: These coincident indicators suggest activity is picking up.
● Possible conclusion: Further evidence that expansion is underway.
Step 3
● Observation: Equity market index has been trending higher. Equity
index is a leading indicator. Analyst checks the aggregate LEI Index.
● Analysis: If the aggregate LEI is moving higher too, evidence suggests
that recovery is underway. Confirmation that output is moving higher.
Or
● If aggregate LEI is not moving higher, analyst cannot draw conclu-
sions about recovery.

Other Composite Leading Indicators

For about 30 countries and several aggregates, such as the EU and G–7, the OECD
calculates OECD Composite Leading Indicator (CLI), which gauges the state of the
business cycle in the economy using the growth cycle concept. One of the interesting
features of OECD CLI is that the underlying methodology is consistent across several
countries. Therefore, it can be compared more easily to see how each region is faring.
Exhibit 13 shows the eight components of CLI used by the OECD. As is usually the
case with leading indicators, some data are based on surveys whereas others are based
on reported market or economic data.
 © CFA Institute. For candidate use only. Not for distribution.
Economic Indicators over the Business Cycle 69

Exhibit 13: OECD Euro Area CLI Components

OECD CLI

Composite indicator Economic sentiment index

of economic tendency
survey results
Residential building permits

Capital goods orders

Euro Stoxx Equity Index

Composite
M2 money supply leading
indicator
An interest rate spread

EurozoneEuro area Manufacturing

Survey – based
Purchasing Managers Index (PMI)

EurozoneEuro area Service Sector Future

Survey – based
Business Activity Expectations Index

The parallels that can be drawn between many of these components and those used
in the United States are clear, but the Euro area includes a services component in its
business activity measures that the United States lacks. Additionally, the Euro area
forgoes many of the overtime and employment gauges that the United States includes.
The OECD CLI for Japan is again similar, but it does include labor market indicators
(unlike the Euro area) and it adds a measure of business failures not included in the
other two.

GERMANY: THE IFO SURVEY

The German ifo survey is a widely used index capturing business climate in
Germany and is published monthly. Exhibit 14 shows how the index moved
ahead of quarterly-reported year-over-year changes in German GDP. It also
shows an uptick in 2018 despite the GDP growth downturn. These indicators
are useful, but they are not foolproof.
​

Exhibit 14: Business Climate Survey and GDP

​

Percent (year-over-year) Index (2015 = 100)

6 110
4 105
2 100
0 95
–2 90
–4 85
–6 80
–8 75
08 09 10 11 12 13 14 15 16 17 18 19 20

GDP (year-over-year) IFO Index

Sources: The ifo Institute and the Federal Statistical Office of Germany.