Only a day after writing “blame Canada” in my post, we got news of Trudeau’s resignation, a move largely tied to Trump’s threatened tariffs. Trump continues to call Canada the 51st state.
One of the biggest themes for markets in 2025 is that of valuations and saying the quiet part out loud, whether certain asset classes or markets are “bubbles”. You see this topic most commonly appear in discussions around MAG7 and AI-related stocks, cryptocurrencies, anything involving Private Credit or “liquid alts” investments. Related topics are indicators like CAPE and the “Buffett Indicator” which are commonly used to identify periods of potential overvaluation.
Back on October 14, 2024, I referenced the two competing “meta-narratives”, one being the proverb that “trees don’t grow to the sky” with the competing narrative that in some ways “this time is different” and there are increasingly companies that are not subject to laws of diminishing returns and earn increasing returns from scale (a reference to work done by James Anderson at Scottish investment firm Ballie Gifford). Somewhat of an accompaniment to this latter narrative of increasing returns to scale is the idea of “winner take all” markets, something we commonly see in sports and entertainment where you have concentrated markets with large prizes. The reality of equity markets has been that most performance comes from a very small proportion of the market (see Hendric Bessembinder titled "Do Stocks Outperform Treasury Bills?"). Related to the former narrative, where there are limits to growth, is history, where empires don’t last forever, where cyclical patterns are observed, where human nature is predictable. Yes, some empires are built, but can you identify which ones and for how long they’ll last on an ex-ante basis?
One of the ideas of passive index investing in the most common market-capitalization weighted indexes (hold all stocks in proportion to their market value) is that you don’t have to find the needles in the haystack, you simply can own the haystack. These cap-weighted index strategies are often and currently criticized because they act as a momentum strategy - buying more of what rises in value and selling those that have fallen in value - that leads to concentration risk and they run the risk of generating a bubble.
Even if you believe that some companies are immune to business cycles or limits to growth, there is still always the question of what’s priced in already. As Morgan Housel states “The valuation of every company is simply a number from today multiplied by a story about tomorrow..” and as Buffett counsels "What the wise man does in the beginning, the fool does in the end." "There are three I's in every cycle: first the innovator, then the imitator, and finally the idiot."
The point of the post today is not to answer whether we’re currently at the “idiot” stage of Buffett’s cycle, but to explain the idea of the business cycle.
The business cycle is the concept that there are recurrent expansions and contractions in economic activity that affect broad segments of the economy. The causes of these cycles can be varied ranging from changes in aggregate demand driven by government spending, interest rates, consumer confidence amongst other factors, to changes in investment and inventory cycles as businesses become more optimistic or pessimistic about their future prospects. Inherent in both of the consumer and business factors are in some ways related to psychological factors around optimism, pessimism and risk-taking. Credit cycles can be another cause of the business cycle and can be closely related to interest rates and lastly there can be external shocks such as wars, natural disasters, pandemics, etc. that can cause or amplify potential cycles.
A “Schumpeterian” view (Joseph Schumpter) could summarize business cycles as caused by “creative destruction”, whereby new innovations constantly emerge and displace older technologies and industries. That process inevitably leads to booms followed by periods of recessions as the economy adjusts to the new landscape. Schumpter believed that recessions were necessary to “clear out” the inefficient businesses and reallocate resources to the more productive businesses.
Whatever the theory related to causes of the business cycle, classically these cycles are measured by fluctuations in GDP, but increasingly they are discussed as measurements around trend or potential growth rates. The business cycle is divided into phases:
Expansion - typically characterized by above trend growth
Slowdown - as the name implies, slowing growth
Contraction - a fall in economic output below potential or trend
Recovery - when economic output starts to increase
Which all leads to two fundamental questions: first how do we know what stage of the business cycle we are in? And second, is the business cycle still relevant to today’s technological advanced, AI-fueled economy?
The first question is more addressable than the second. Attempts to determine the current phase of the business cycle are typically made by reviewing economic variables that are classified as leading (ex. stock market performance, new orders), lagging (ex. Inflation, duration of unemployment) or coincident (ex. Industrial production), making use of big data (ex. Chicago Fed National Activity Index), making use of survey data and nowcasting (GDPNow) amongst other approaches.
There isn’t always consensus over where we are in the business cycle, at present you can find some “experts” who would say we’re in the late innings of expansion and others who believe we’re much earlier in the expansion phase.
As for the question of whether business cycles are still relevant today, maybe the better question is whether valuations can get too far removed from the ultimate reality that Warren Buffett describes, "The most that owners in the aggregate can earn between now and Judgment Day is what their business in the aggregate earns."
Tomorrow we’ll take another look at a different but related cycle, this one the credit cycle that is inherent in Hyman Minsky’s Financial Instability Hypothesis.
XTOD: Released the @PermanentEquity annual letter this morning: https://permanentequity.com/content/2024-annual-letter It's long, so here's the section on manically pursuing success, gaining 50+ lbs, almost getting divorced, and why I relate so much to Forrest Gump. Hope it helps someone out there.
XTOD: Nikki Glaser crushed Golden Globe roast: - “Ozempic’s biggest night!” - “You’re all so famous and powerful. You can do anything, except tell the country who to vote for.” - “The Bear. The Penguin. Baby Reindeer, these aren’t just things in RFK’s freezer.”
XTOD: There’s a nontrivial chance that Trump’s new term is the actual catastrophe that liberals imagined his first one would be. I don’t mean authoritarian, I mean economic, military and social collapse.
XTOD: We humans are just not very good at updating our beliefs in the face of new information, ๐๐ฃ๐๐ ๐๐๐ก๐๐ ๐๐๐๐๐๐๐ ๐๐ ๐๐๐ก๐๐๐๐ ๐๐๐๐ข๐ก โ๐๐ค ๐๐๐ ๐คโ๐ฆ ๐ค๐๐๐ ๐๐๐ ๐๐๐ก ๐ฃ๐๐๐ฆ ๐๐๐๐ ๐๐ก ๐ข๐๐๐๐ก๐๐๐ ๐๐ข๐ ๐๐๐๐๐๐๐ ๐๐ ๐กโ๐ ๐๐๐๐ ๐๐ ๐๐๐ค ๐๐๐๐๐๐๐๐ก๐๐๐. When the facts and our beliefs come into conflict, the facts usually lose out. My latest Substack on confirmation bias, motivated reasoning, and cognitive dissonance. https://annieduke.substack.com/p/oops-i-read-the-comments
https://x.com/BrentBeshore/status/1876343485084922365
https://x.com/TrungTPhan/status/1876093854610501658
https://x.com/matthewstoller/status/1876269641229803886
https://x.com/AnnieDuke/status/1876369677737148467