Follow the Market’s Cues

In the spring of 2000, as the Nasdaq began its slide into one of the worst bear markets in history, countless business executives missed the signal. Lulled by low unemployment and a robust GDP growth rate, they got caught with their inventories up and expansion plans under way when they should have been battening down the hatches. The market foresaw a contracting economy, even if they didn’t. If only they’d heeded its warning. Any executive who fails to read the market is missing crucial cues—signals that can guide decisions about everything from production and inventory management to capital spending and marketing. Of course, most executives know that the market is a leading indicator of general economic activity. But it offers more subtle guidance as well. Consider the relationship between the broad stock market cycle and the specific patterns of sector rotation for individual economic sectors. At the top of the stock market cycle, for example, when the business cycle is in the late stages of expansion, many of Wall Street’s professional money managers will begin to defensively rotate funds into “recession proof” health care and noncyclical consumer sectors like pharmaceuticals, cosmetics, and food, anticipating the leaner times to come. Knowing when your sector’s performance is likely to peak during the market’s cycles can inform broad strategic decisions as well as more tactical ones. Witness the case of the California-based company Calpine. Calpine is in the independent power production sector, along with rivals like Dynegy, Reliant Energy, and Mirant. This sector sits in the broader energy category. Energy is an undifferentiated bulk commodity, which typically experiences only a brief, shining moment in the overall business cycle, tending to peak in the late bull phase of the stock market cycle. When the economy is running at full bore, energy supplies are tight, demand is red hot, and prices in this otherwise highly competitive market tend to rise dramatically along with profits and stock prices. Once the economy turns down, prices soften swiftly and depress profits in the face of overcapacity and cutthroat competition. In February 2001, as the stock market’s continuing slide signaled an impending recession, Calpine announced that it was upping its capital expansion target to an astonishing 70,000 megawatts of generating capacity by 2005. The expansion would have made Calpine the largest power producer in the country. Unfortunately, Calpine’s aggressive move couldn’t have come at a worse time: The recession began the following month. Calpine suffered a severe reduction in cash flow just as it assumed massive additional debt to finance the expansion. By the time its executives realized that the company was dangerously over-leveraged, it was too late. Calpine’s bond rating had dropped to junk status, and its share price had fallen from a high of $ 58 in March 2001 to a low of $ 7 in February 2002. One month later, Calpine announced it was slashing its growth targets and putting more than half of its pending projects on hold. Calpine’s mistake was that it ignored its sector’s place in the business cycle and failed to see the recession coming. Savvy executives in this sector would be leery of any expansion plans in a stock market signaling recession, even if their companies’ current economic results appeared robust. This is particularly true in highly capital-intensive industries like electricity, which must service large amounts of debt with revenue that is likely to fall off steeply in a recession. The bottom line: Calpine executives failed to appreciate that energy sector businesses need to hunker down—not expand—as the business cycle crests and the stock market enters its early bear phase. Contrast Calpine’s strategy with the cycle-sensitive approach of the German semiconductor manufacturer Infineon Technologies. In December 2001, foreseeing that the late bear market would likely soon bottom out, Infineon’s CEO Ulrich Schumacher announced that the company would begin producing the largest silicon wafers in the industry, a key to capturing production efficiencies. In making the announcement, he observed, “If you want to prevail in tomorrow’s semiconductor market, you have to be willing to make counter-cyclical investments today.” The company is clearly anticipating an economic recovery, mindful that typically the semiconductor-manufacturing sector performs best in the early phases of an expansion. If the recovery emerges as forecast, Infineon will be perfectly positioned as one of the lowest-cost producers when the semiconductor cycle hits its sweetest spot. Calpine’s and Infineon’s stories remind us that the broad stock market trend is the best leading indicator of future economic conditions and that sector trends increase the picture’s resolution. If the market expects recovery in the months ahead, it never waits for the actual expansion to begin. Perhaps neither should any executive seeking an advantage over competitors.

Follow the Market’s Cues

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