Visualizing the Business Cycle

Visualizing the business cycle requires understanding a formula incorporating the S&P 500, unemployment rate, inflation, and interest rates, as recessions typically mark the end of these cycles, often leading to hard or soft landings.

• Business cycles can be visualized with a formula combining S&P 500, unemployment rate squared, inflation, and interest rates.

• Recessions historically conclude business cycles, bringing market valuations back to reasonable levels.

• Preparing for a potential hard landing with hedged investments or cash can allow investors to capitalize on future market lows.

The business cycle, which many millennials have not fully experienced, can be better visualized using a formula that combines the S&P 500, squared unemployment rate, inflation, and interest rates. This metric consistently shows that business cycles peak with 'bubble-like behavior' before a recession brings the curve back down to reasonable levels. While historical patterns suggest a potential hard landing is always a risk, there are also instances of soft landings where the market only corrects moderately.

Visualizing Business Cycles

• 00:05:35 A key formula to visualize the business cycle involves dividing the S&P 500 by the unemployment rate squared, then multiplying by the inflation rate and interest rates. Squaring the unemployment rate in the denominator significantly amplifies its impact, reflecting its historical importance in signaling the final phases of a business cycle. This metric effectively illustrates cyclical peaks and subsequent returns to baseline levels driven by recessions.

Historical Recession Patterns

• 00:08:00 Historical data, particularly since the 1970s, reveals a clear pattern: business cycles often culminate in 'bubble-like behavior' before a recession brings valuations back down. While recessions were more frequent in the 1800s, their duration between occurrences has lengthened over time, sometimes spanning a decade or more, though each cycle consistently ends with a downturn to normalize market conditions.

Soft vs. Hard Landings

• 00:14:18 Not all market corrections leading to a return to cycle lows are catastrophic; some are 'soft landings,' like the 1990 recession where the market corrected only 20%. In contrast, 'hard landings,' such as those in 2000 and 2008, involve more severe market drops. The challenge for investors is predicting whether the current cycle will result in a soft or hard landing, as the market often bottoms before the recession officially ends.

Current Cycle Outlook

• 00:27:15 Current market conditions show underlying weakness in the labor market, with declining hiring, quits, and job openings, even though the unemployment rate has not yet entered a non-linear trajectory. A significant stock market correction (10-20%) could trigger a negative feedback loop of layoffs, decreased demand, and further layoffs. The expectation is that the current business cycle will end within the next 2-3 years, potentially with a hard landing due to high global uncertainty, making hedging strategies advisable.