The Financial Situation

Profiting From a Knowledge of Business Cycles

MERRYLE STANLEY RUKEYSER

IN modern business, there is a perpetual ebbing and flowing of the tides. Economists who have' studied these habits of flux have described the process as a business cycle, the various phases of which include a revival of activity intense prosperity, a crisis, and a depression.

Popular thinking about the vicissi tudes of commerce in terms of the cycle theory at the moment is at a peak of popularity. The view that the seeds of prosperity are sown in a period of depression and vice versa is a helpful aid to envisaging changes in a broad perspective. In so far as the business cycle theory is truly understood (as a description of the average flow of events between hard times and good times in leading industrial countries), it facilitates reasoning about elusive trade facts. When, however, as frequently occurs, the layman ascribes to the theory the universality of Newton's law of gravitation or Einstein's deductions regarding relativity, it is high time for some one to urge that the alleged freedom of the will has some bearing on the struggle of mankind to make a living. Those who misunderstand the business cycle notion become utterly fatalistic about the fluctuations of business and resignedly feel that nothing in the power of man can either hasten prosperity or delay severe recessions.

The absolute contrary is nearer the truth. As the view that more or less definite cycles follow one another in the world of give and take is more widely accepted, the mere knowledge will tend to lessen the intensity of the changes, The more astute men of business attempt to anticipate changes, and this tendency to discount adjustments in advance in turn spreads the disposition to change over a longer period of time—flattening the peaks and the depressions. Every serious attempt to make known to the enterprising publie the true facts regarding current business checks in a small way the wideness of the swings between changing phases.

IN 1913, Dr. Wesley Clair Mitchell wrote his classic work on "Business Cycles", (published by the University of California), which now unhappily is out of print, and crystallized American thought on the subject. In the upwing of the war period, relatively littie attention was paid to the abstract reasoning, but during the setback subsequently and the beginnings of a revival later the theory has come into new vogue. Many explanations of business cycles had been made by earlier writers. A business cycle theory was set forth in the Bible, which taught that there would be seven fat years followed by seven lean years. Of course, the business of the speculator, who assumes the risks of business, is to anticipate these shifts of the favoring winds.

The Mitchell theory is a descriptive analysis of the processes of cumulative change by which a revival of activity develops into intense prosperity, by which this prosperity engenders a crisis, by which ensis turns into depression, and by which depression, after growing more severe for a time, finally leads to such a revival of activity as that with which the cycle began.

The economic situation in America after the war was in many ways unprecedented, and any observer who tried to explain it wholly in terms of the nasi was inevitably elbowing his way towaM a precipice. And yet in the present period 0f business recovery, after the severe slump 0f 1920 culminating in the attainment o£ the most depresed speculative prices in August 1921, many elements correspond roughly with the conditions of this phase of a theoretical cycle as described by Dr. Mitchell.

"A revival of activity " he "slarts with this legacy from depresslon: a of prices low in comparison with the prices of prosperity, tic reductions in the costs of doing busi. ness) narrow margins of profit; liberal bank reserves, a conservative policy ⅛ capitalizing business enterprises and ⅛ granting credits, moderate stocks of goods, and cautious buying.

"Such conditions are accompanied by an expansion in the physical volume of trade. Though slow at first, this expan. sion is cumulative. Now it is only a question of time when an increase in the amount of business transacted, which grows more rapid as it proceeds, will turn dullness into activity. Left to itself, this transformation is effected by slow degrees, but it is often hastened by some propitious event arising from other than domestic business sources.

"Even when a revival of activity is confined at first within a narrow range of industries, it soon spreads to other parts of the business field. For the active enterprises must buy more materials, wares and current supplies from other enterprises, the latter from still others, and so on without assignable limits. Meanwhile, all enterprises which become busier employ more labor, use more borrowed money, and make higher profits. There results an increase in family incomes and an expansion of consumers' demand, which likewise spreads out in ever widening circles, Shop keepers pass on larger orders for consumers' goods to wholesale merchants, manufacturers, importers and producers of raw materials. All these enterprises require more supplies of various kinds for handling their grocery trade, and increase the sums which they pay out to employees, lenders, and proprietors—thus stimulating afresh the demand for both producers' and consumers' goods. Sooner or later this expansion of orders reaches back to the enterprise from which the impetus to greater activity was first received, and then this whole complicated series of reactions begin afresh at a higher pitch of intensity. All this while, the revival of a activity is instilling a feeling of optimism among businessmen, and this feeling both justifies itself and heightens the forces which engendered it by making every one readier to buy with free-

"While the price level is often sagging slowly when a revival begins, the cumulative expansion in the physical volume of trade presently stops the fall and starts a rise. For, when enterprises have in sight as much business as they can handle with existing facilities of standard efficiency, they stand out for higher prices on additional orders, The expectation hastens tfye advance.

"Like the increase in the physical volume of trade, the rise of prices spreads rapidly, for every advance of quotations puts pressure upon some one to recoup himself by making a compensatory advance in the prices of what he has to sell.Wages rise often more promptly, but always in less degree than wholesale prices; discount rates rise sometimes more slowly than commodities and sometimes more rapidly; interest rates on long loans always move sluggishly in the early stages of revival, while the prices of stocks—particularly of common stocks—precede and exceed commodity prices on the rise.

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"In the great majority of enterprises, larger profits result from these divergent price fluctuations, coupled with the greater physical volume of sales. For, while the prices of raw materials and of wares bought for resale usually, and the prices of bank loans often., rise faster than selling prices, the prices of labor lag far behind, and the prices which make up supplementary costs are mainly sterotyped for a time by old agreements regarding salaries, leases, and bonds.

"The increase of profits, combined with the prevalence of business optimism, leads to a marked expansion of investments. Of course, the heavy orders for machinery, the large contracts for new construction, etc. which result, swell still further the physical volume of business, and render yet stronger the forces which are driving prices upward.

BEFORE essaying to suggest the practical applications of this analysis of the business man and the investor, we shall indicate at what phase of the business cycle we are at present by the citation of a few barometric, statistical facts.

Credit has become incredibly easier. Since November S, 1920, peak of loan expansion in American banking, twelve Federal Reserve Banks have shrunk from $2,826,825,000 to $405, 083,000 on September 6, 1922, a decrease of 85.7 per cent. Only July 26 of this year, the borrowings of members banks at the central institutions was down to $380,000,000, the slightest figure attained since the war. In New York City the ordinary banks are virtually without indebtedness at the Federal Reserve Bank, which means that their capacity for credit expansion is exceedingly large, particularly since the loaning capacity of American banks was greatly enhanced through the influx from abroad of $410,240,000 of gold in the first seven months of the year. This superabundance of credit at a time when lower commodity prices and restricted trade made the demands of current business for funds relatively light enabled banks to direct torrents of resources into investment issues. Between January of this year and the end of August, 791 typical member banks increased their investment holdings from $3,000,000000 to $4,532,000,000. This type of buying played no insignificant role in the market value of investment bonds, twenty-five representatives of which increased their average price from 83.22 on January 1, 1922 to 90.46 on September 1, 1922 compared with a low price of 75.25 in 1921.

Since July, 1921, the march of bend quotations has been almost uninterruptedly upward. By this process, the yield to the new investment buyer was steadily cut down, as interest rates on call money, commercial paper and acceptances similarly declined, making the lot of the borrower less burdensome. The investment market has been having no ordinary recovery; it has been reacting from the abnormal excesses of a war market. Companies with the privilege have been redeeming outstanding bonds and issuing in their stead new ones bearing a lower interest rate. The upward movement, of course, cannot last forever. If rising tendencies were unchecked for a few seasons longer, the lender would have to pay the borrower a premium for his courtesy in accepting the funds.

When commercial needs expand, members banks will have to augment their supply of funds available for lending. Broadly, they can do this in two ways, first, by borrowing at the federal Reserve Banks, and, secondly, by liquidating a share of their long term government and corporate bonds. When the banks begin selling bonds, forces will be set free at the marketplace to tend to counteract the impulses which for more than a year have been driving quotations markedly upward.

THE same factors will not have a corresponding effect on common stocks, which will benefit from any substantial improvement in business. From the end of August 1921 up to the time of writing this article, the trend of stock quotations has been toward higher levels. The fountain and springs from which strength was derived were the progressive easement of money conditions and trade revival, actual and prospective. During the first year of recovery in the market, speculators paid scant attention to the current net earnings of corporations whose shares they bid skyward. Traders based their operations largely on the fact of easy money and the belief that it would greatly stimulate trade activity. Now a new phase in the market cycle has been reached, and, although the factors of the last year will continue to operate to a degree, speculators will concentrate more upon the actual earnings of individual corporations and the prospects for extra dividends. Of course, if we are drifting toward a period of intense prosperity, common shares will be most favorably affected.

To take advantage of all the phases of a business cycle, the holder of securities would have to shift his securities from time to time. He would buy common shares at a tail end of a period of depression and hold them during a time of revival and sell them when on toward the close of an era of high prosperity. Then he would acquire bonds before the time of industrial crisis, during which high money rates would tend to support the market value of his bonds at a time when shares, discounting adversity, would tumble in market worth.. With interest rates mounting at sUch a time, some operators find it advisable for a time to keep their funds especially liquid so that they can observe changes and be in a position instantly to act after having reached a decision. They thus either keep their funds unprofitably idle at the bank, or invest then, in high grade bankers' acceptances or in call loans at the New York Stock Exchange. Efforts to take advantage of all the vast fluctuations of an inefficiently geared industrial system, whose ebb and flow are a source of injury to the many would involve also subtler switches from long term to short term bonds, and at other phases of the cycle from one type of stock to another.