Since the year 1900, recessions have occurred on average every four years. This business cycle, which began in 2009, has been unusually long. In fact, it is currently the third longest economic expansion in history; surpassed only by the 1960’s (Cold War arms race), and the 1990’s (Internet Boom). These unusually long economic expansions tend to end with more severe contractions resulting in larger declines in financial markets.
Let’s first start with the 1960’s. During that time the US Economy had asserted itself at the dominant engine of global economic growth. In fact, between 1960 and 1968, the US Economy increased in size by roughly 50%. To provide some context, the current economic expansion has produced a roughly 14% increase in the economy over a similar amount of time. This long period of economic prosperity would eventually come to an end as all cycles do. Between 1968 and 1973 the economy experienced two recessions that resulted in large stock market declines. Between November of 1968 and May of 1970, the S&P 500 fell 36%. This was followed shortly after by a 3-year slump beginning in 1973 that produced a 50% decline in stock prices.
Fast forward to the 1990’s, which was the longest economic expansion on record. During this time the economy expanded by nearly 40% and the stock market raced to new highs. In fact, between 1995 and 1999, the stock market rose by at least 20% for five consecutive years. Alan Greenspan, the Chairman of the Federal Reserve, earned the title “Maestro” for having helped the economy produce its longest expansion on record. This period in history would later become known at the DotCom Bubble. This period of economic prosperity would eventually give way to one of the worst decades for investors. Between the year 2000 and 2010, the US economy would suffer two painful recessions both of with resulted in severe declines in equity prices, -49% between 2000 and 2002, and -57% between 2007 and 2009.
Big economic booms tend to produce larger economic and financial market downturns.
So where do we stand today?
This economic expansion is now in its 103rd month. It has produced a staggering 421% gain in the S&P 500, climbing from 667 in March of 2009, to 2,810 today. The duration of this economic expansion has been impressive, but the pace of economic growth leaves a lot to be desired. The current expansion has produced a 14% increase in economic output (GDP). That might sound good, but it’s paltry when compared to the 50% expansion we experienced in the 1960’s or the 40% we saw during the 1990’s.
Simply put, equity prices have drastically outpaced the growth experienced by the real economy. This alone is not a cause for concern, given that equity prices were so depressed during the 2008 Financial Crisis. However, there are some signs that should give investors reasons to worry.
The first, is the relatively high valuation of equity markets. Currently, the S&P 500 trades at about 18.5 times it’s expected 2018 earnings of $150. This is above the long-term average of 16 times, but not by an alarming amount. However, during periods when the US Economy experiences a recession, the S&P 500 typically trades at just 10 times forward earnings. Assuming earnings are not impacted by the next recession, which is HIGHLY UNLIKELY, the S&P 500 would drop from 2,810 to 1,500. That’s a 46.6% decline assuming that corporate earnings don’t take a hit during the next recession. Based on valuations alone, one could argue that the next recession could bring a 50-plus percent decline in equity prices.
While valuations are stretched, this alone is not a reason to panic. It’s rare for the value of stocks to fall without there being a risk to the earnings potential of the underlying companies. With the economy expanding by roughly 3% in 2017, and carrying that momentum into 2018, the risks to corporate profits appear low.
It’s become common knowledge that excessive levels of debt, primarily by households, exacerbated the Financial Crisis in 2008. During the course of this expansion, banks have avoided making risky loans to questionable borrowers. This is beginning to change. I recently saw an advertisement that touting mortgages which require only a 3% down payment. Déjà vu all over again?
The real problem today isn’t the consumer, it’s corporations. During this economic cycle the total amount of corporate debt has ballooned from $3.3 Trillion in 2007 to $7.5 Trillion today. Fueled by extremely low interest rates, corporations took advantage by issuing debt in the public markets, and in many cases, used the proceeds to purchase their own stock. Essentially, this financial engineering has produced a massive amount of additional demand for stocks.
When the next recession comes, debt burdened corporations may have to reverse the process of borrowing to purchase their stock. Instead, they will likely be forced to sell stock in order to fund their operations and to pay down the additional debt they have taken on. This could produce a more severe decline in the stock market if enough companies are forced to sell.
None of this should “sound the alarm” or cause you to panic; at least not yet. Over the last 50 years, there hasn’t been a recession without our Business Cycle Indicator first providing a warning. The average lead time of our indicator is 13 months, and currently, it’s not providing any warning that a recession is imminent. That being said, recent movement in several underlying components are hinting that a warning might not be far off.
Panicking and deciding to get out the market can be a costly mistake. In years that our Business Cycle Indicator IS NOT warning of a recession, the return for the S&P 500 averages close to 15% per year. Countless billions of dollars have been lost by individual investors who decided to sell because they got nervous. During this cycle alone there have been plenty of reasons to sell – Greece Potential Default in 2010, European Debt Crisis in 2011, Downgrade of US Treasury Debt in 2011, Fed Tapering Bond Purchases in 2013, Fed Ends Bond Buying Program in 2014, China Devalues their currency in 2015, Oil Price Collapse in 2016, US Election in 2016, Britain Leaves the European Union in 2016, and list could go on and on.
For all the risks that we’ve seen come and go during this cycle, the prudent thing to do has been to stay the course. Stay invested and don’t get caught up in the headlines. At the end of the day, few headlines have any impact on the cycle of the US Economy. If the economy continues to expand, like it has for 9 years now, corporations will find a way to increase their profits which will continue to push stocks higher. Surely, we’re going to see some hiccups along the way. Historically, the average decline in the stock market in any calendar year is 14%. So, don’t be surprised if we see some ups and downs over the course of 2018.
The only reliable predictor of a significant stock market decline is the end of a business cycle. Over the last 100 years, recessions have accounted for 8 out of the 10 instances where the stock market fell by 20% or more. Our Business Cycle Indicator isn’t warning of a recession yet, so staying invested is still the best course of action. However, high equity valuations coupled with record amounts of corporate debt increases the odds that stocks will suffer an above average decline during the next recession.
For the time being, stay the course. We’ll be providing regular updates on the status of our Business Cycle Indicator.