What Can Capital Markets Teach Entrepreneurs?

This article was originally featured in Fast Company.

Which forward-looking capital market indicators should you pay attention to—and how do you use the information to inform strategy for your business?

The capital markets lead the economy, not the other way around. If you have followed me at all, you may have heard me say this—it’s the title of many of my presentations, and it’s even made its way into our company’s “cardinal rules” for investing.

Before we talk about why, let’s define some terms. Capital markets encompass stock, bond, credit, and commodity markets, and each day they send us messages about the future in a much more informed and reliable way than we might get from, say, economists (of which I am one). Therefore, everything I have to tell you I say with humility, because, as John Kenneth Galbraith once said, the only function of economic forecasting is to make astrology look respectable!

Knowing where the economy might be going is not just about having a crystal ball; it’s a critical component when thinking about how to prepare your business to take advantage of opportunities. For example, as much as everybody dreads a downturn or recession, they can be massive opportunities for appropriately positioned businesses to be predators, not prey, and to take advantage of others’ complacency and distress.

Think of economists like you do cardiologists. They know the set of circumstances that are likely to predict an economic seizure, but they can’t tell you precisely when it is going to happen with enough lead time to make adjustments. They are most helpful once the event occurs and resuscitation is needed.

That’s because while economists have useful theories to explain the way the world works and where the economy is or has been, the data they use to forecast is often backward-looking and subject to revision. In fact, both The Economist and The Financial Times have written about the fact that economists have a lousy track record of predicting downturns over a useful forecasting horizon, such as 12-18 months. If you’re a business owner, you know you need several months to course correct around a strategic plan that will allow you to capitalize on any opportunity that might be present.

Now that you know you’re not obligated to listen to economic analysis and newscasters who prey on your emotions, which forward-looking capital market indicators should you pay attention to—and how do you use the information to inform your business’s strategy?

BOND MARKET

The bond market is typically the first to signal an impending downturn. The difference in interest rates on short- and long-term bonds of the same credit quality can tell us where interest rates are today and where they will likely be in the future.

When long-term rates are higher than short-term rates, the yield curve is positively sloped, a signal that the economy is going to do well. When the yield curve flattens or inverts in a sustained way, it creates a headwind to banks’ willingness to lend to businesses—a reliable indicator that the economy will slow within 12 to 18 months.

So, when you observe a positively sloped yield curve, you want to revisit your capital suppliers and lean into your banking relationships to increase credit lines so that you have cash reserves ready in advance of a downturn.

STOCK MARKET

There are very few instances of general economic recession without corporate profits contracting, which says a lot about how important business is to the American economy.

Stock prices reflect expectations of current and future profitability. In general, when they fall by 20% or more for a sustained period of time—known as a “bear market”—it is typically recognized as heralding the likelihood of an economic downturn.

Don’t just pay attention to the Dow Jones or S&P 500 indices, look at the broader Russell 1000 or the Wilshire 5000 indices, which reflect the future profitability of medium- and smaller-size businesses as well.

CREDIT MARKET

Lower-quality corporate bonds typically trade at a 5% premium over their equivalent in safer Treasury Bonds when corporations are floating their own bonds outside of the bank lending channel. When corporate spreads exceed this watershed mark, investors anticipate greater defaults—an indicator that the economy is going to slow down. This is typically the third stage in the early stages of an economic downturn.

But these signals from the bond, stock, and credit markets should not be viewed in isolation. Rather, they should be viewed in tandem to build a mosaic of corroborating evidence about the domestic economic outlook.  

COMMODITY MARKET

Finally, the health of the global economy cannot be ignored. The U.S. is still the largest and most diverse economy in the world, but it no longer produces the majority of global economic growth.

That now belongs to a cluster of economies often referred to as the emerging or developing world, of which China is the key player. These economies are dependent on consuming commodities that are used in the production of things. So much so that the price of copper, for example, has become known as “Dr. Copper” for its forecasting prowess on the health of the global economy. When it slumps in a sustained way, that is an additional harbinger of coming economic weakness potentially imported from abroad.

These capital market messages are sent to us every day and are readily available on any financial website. Paying attention to them collectively—and instead of the mainstream media headlines, which are mostly designed to prey on your emotions—is likely to offer far better and more objective insight into what is coming down the economic turnpike.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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