Follow the Market’s Cues

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 miss the signal. Lull 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 he its warning.

Any executive who fails to read the market is missing ucial cues—signals that can guide decisions about everything from ion and inventory management to capital spending and marketing. Of course, most executives know that the market is a leading indicr of general economic activity. But it offers more subtle guidance as well.

ider the relonship between the broad cycle and the specific patterns of sector roton for individual economic sectors. At the top of the cycle, for example, when the business cycle is in the late stages of expansion, many of Wall Street’s professional money managers will ben to defensively rotate funds into “recession proof” health care and noncyclical umer sectors like pharmaceuticals, cosmetics, and food, anticipng the leaner times to come. Knowing when your sector’s performance is likely to peak during the market’s cycles can inform broad stratec decisions as well as more tactical ones.

Witness the case of the California-bas company Calpine. Calpine is in the independent power ion sector, along with rivals like Dynegy, Reliant Energy, and Mirant. This sector sits in the broader energy category. Energy is an undifferentiat 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 cycle. When the economy is running at full bore, energy supplies are tight, demand is r hot, and prices in this otherwise highly competitive market tend to rise dramcally along with profits and stock prices. Once the economy turns down, prices soften swiftly and depress profits in the face of over and cutthroat competition.

In February 2001, as the ’s continuing slide signal an impending recession, Calpine announc that it was upping its capital expansion target to an astonishing 70,000 megawatts of generng 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 suffer a severe ruction in cash flow just as it assum massive additional debt to finance the expansion. By the time its executives realiz that the company was ously over-leverag, it was too late. Calpine’s bond rng had dropp 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 announc it was slashing its growth targets and putting more than half of its pending projects on hold.

Calpine’s mistake was that it ignor its sector’s place in the business cycle and fail to see the recession coming. Savvy executives in this sector would be leery of any expansion plans in a signaling recession, even if their companies’ current economic appear 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 fail to appreciate that energy sector businesses ne to hunker down—not expand—as the business cycle ests and the enters its early bear phase.

Contrast Calpine’s strategy with the cycle-sensitive approach of the German semiconductor manufacturer Infineon Technoloes. In December 2001, foreseeing that the late bear market would likely soon bottom out, Infineon’s CEO Ulrich Schumacher announc that the company would ben producing the largest silicon wafers in the industry, a key to capturing ion efficiencies. In making the announcement, he observ, “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 anticipng 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 position 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 trend is the best leading indicr of future economic conditions and that sector trends inease the picture’s resolution. If the market expects recovery in the months ahead, it never waits for the actual expansion to ben. Perhaps neither should any executive seeking an advantage over competitors.

Follow the Market’s Cues



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