Understanding Economic Cycles, Sentiment and Valuations

Daniel Hawley |

"Nothing is so treacherous as the obvious" observed Joseph A Schumpeter the famous Austrian political economist who is regarded as one of the 20th century's greatest intellectuals and best known for his theories on business cycles and the development of capitalist economies as well as for introducing the concept of entrepreneurship.

Cycles, whether they be seasonal, economic, or personal, are inextricably tied to life. History has proven that economies rise and fall, and asset prices rise and fall as sure as night follows day. An economic cycle for example is defined as consisting of four distinct phases: expansion; peak; contraction; and trough. Each economic cycle comprises of these four phases. It is also fair to say that one can observe larger economic cycles within which several economic cycles may play out. If you could anticipate, plan, and organize around each stage of these cycles you would inevitably become more astute in any number of professional fields that require the purchase and sale of any asset, service or commodity. If economic cycles are inevitable which they are, why are they not then more predictable? This brings us back to the opening quote in this article by Joseph A. Schumpeter "Nothing is so treacherous as the obvious". How often do we grapple with an issue - any issue - only to say after days. months or years have gone by that the answer or solution had been staring us in the face, except for the fact that we did not see it.

The obvious is sometimes anything but and can be easily obscured by the very human attributes that make us...human. Whether it is hope, denial, greed, doubt, disbelief, attachment to an ideal, theory or assumption that we learnt or inherited in our past or took at face value from an expert, any of these factors can obscure the "obvious".

If economic cycles are inevitable, why are they inevitable? The objective of this piece is not to provide any definitive answers but to consider some of the influencing factors at play. Let's start with:

The Credit Cycle

The availability of credit to both commercial enterprises and individuals and qualifying for said credit is a key component influencing economic expansion or contraction. The source of credit is banks which are - in the modern-day area - intricately tied to a central banking system, in the case of the US, the Federal Reserve. One of the core ways banks make money is through the spread between the cost of the funds they take in and the interest rate at which they lend out those funds. In a fractional reserve banking system, the ammount of deposits and the asset base will determine the degree of leverage or the quantity of funds available for a bank to lend out. A measure of the strength of an economy is the delinquency rates across various debt instruments. The lower the rate of delinquencies, whether it be credit cards,car loans, real estate loans, business loans or fraud etc., the stronger the economy. As delinquencies rise in specific sectors or across multiple sectors, depending on the findings or analysis this this can signal weakening economic activity or troublespots in a sector or the broader economy.

As delinquencies rise or cross a cumulative threshold, banks/investors invariably become more cautious, and credit tightens. We may see business and bank failures or sigificant layoffs. As credit tightens, liquidity is withdrawn from the economy and there is less "fuel" for expansion.

Booms invariably lead to over expansion and inflated asset prices.

The availability of credit and a strong economy almost always leads to over-expansion and the availability of excess capacity over and above demand in any number of business sectors. Where assets are in more limited supply, but demand is strong, availability of credit and liquidity will almost invariably lead to inflated asset prices. Signs of economic cycle peaks are always accompanied by expansive projects and inflated prices.


The stronger the economy the less risk averse credit, venture capital and capital markets become and more capital moves from the lower risk to the higher risk spectrum of asset classes. The weaker the economy becomes the process then moves in reverse.

The New New Thing

Each new expansionary cycle is typically fueled by what is perceived by the financial and business community as a breakthrough innovation or area that is going to usher in significant economic benefit whether it be the computer, the smart phone, the internet, autonomous cars, robotics, biotechnology and more recently quantum computing and artificial intelligence and the convergence of all technologies accelerating human progress at rates never seen before.  


Positive sentiment is typically higher when things are going well and turns negative when things are not going so well. Sentiment fueled by the forces of credit availability, rising asset prices, liquidity, a strong economy and the new new thing makes for a less-risk averse environment and by extension more expansionary environment.

Conversely, if delinquencies rise or some negative event or series of events happen and the outlook begins to sour, credit conditions may tighten, banks or hedge funds may fail, liquidity is withdrawn, and sentiment begins to shift more negatively.

Sentiment will tend by nature to osscilate between extreme highs and lows.

While the above are typical influencing factors that accompany each part of the economic cycle, they are not an echaustive list. We are simply pointing out some common denominators that accompany each economic cycle. It is interesting given the fact that economic cycles are inevitable, guarranteed even, that so many experts fail to accurately read the economic cycle or see the transition points.

Valuations of any asset class are often determined by sentiment or the perceived future value/demand which is highly influenced by the stage of the economic cycle we are in and how limited and desirable the asset class is. Valuation is a subjective measure that will oscillate with the economic cycle. The more scarce and desirable the asset class in question the better it's value will likely be maintained providing sentiment is at least constant.

It is hard not to be "positively effected" when sentiment is high and conversely "negative" when sentiment is low. As investors, entrepreneurs, or wealth builders/managers we need to be able to check our “sentiment” meter at the door. We need to be able to “observe” and “analyze” the economic cycle and where we might be in the cycle in addition to any related unique personal or business circumstances so that we can make the most economic advantageous decisions as objectively as possible and at the very least not make decisions that are detrimental to our economic well-being.

Not doing so can lead to less than optimum decisons and outcomes which in hindsight may of course become more obvious which is why "Nothing is so treacherous as the obvious" as Joseph A Schumpeter observed. We all have stories in some area of our lives that can testify to the truth of this.