The madness of crowds, stocks and the business cycle

For a description of business cycles in emerging economies probably the best is found in Dr. Marc Faber's brilliant book 'Tomorrow's Gold'. He divides the business cycle into six phases.

The easiest to recognize is phase three of the cycle. Dr. Faber lists its characteristics: stocks and real estate are a topic of discussion everywhere; the volume of credit explodes; housewives become active in the stock market; foreign money flows reach a very high level; and there is an explosion of real estate and infrastructure projects.

'The boom is usually erected on a massive popular delusion', states Dr. Faber. 'Happy times and excessive prosperity do not last forever. Something totally unexpected will happen to spoil the party. But prices can also begin to fall under their own weight.'

In the GCC stock markets the Qatar insider trading scandal this spring is an example of such an 'unexpected event' which caused a major correction in this overheated stock market.

However, it is in phase four of the emerging market business cycle that investors really begin to lose money. In phase four, credit slows and profits begin to decline but shares pick up off their initial decline which marks the move from phase three.

'Excess capacity becomes a problem in a few industries but overall the economy continues to do well and the slowdown is perceived to be only temporary,' explains Dr. Faber. 'Some kind of a hook will continue to keep investors interested.'

But by phase four most stocks will no longer keep reaching new highs and investors will keep losing money by buying on the dips.

In phase four there will also be some financial distress as some highly borrowed speculators are forced to sell out; real estate prices will be beyond what local buyers will pay at this stage, and rentals will level off or begin to fall; tourist arrivals also start to decline.

Now from here the emerging economy moves into the last two painful stages. In phase five bankruptcies soar, corporate profits collapse, real estate prices slump and stocks enter a severe downturn. In phase six speculators finally give up on stocks, capital spending slumps and foreign investors sell-out.

Of course, it is impossible to predict the exact timing of such a scenario, especially in the context of the GCC states buoyed by record oil prices. But Dr. Faber's examination of the phases of the business cycle holds true for almost any past example of emerging economies, and the wise business observer would be foolish to ignore it.

However, the business cycle is a natural function of economic progress, and GCC economies will not disappear whatever happens. It is more that the relative fortunes of those participating in these economies will rise and fall according to the position of the business cycle.