July 2018 will mark the 108th month of the economic recovery, making it the second longest expansion in history. Another 12-months or so and it will be the longest ever. Moreover, the consensus of economists foresees little trouble ahead. As of May 2018, Goldman Sachs US Economic team’s probability model assigned just a 5% likelihood of a recession during the next four quarters, with a 19% probability for the next two years. If they are right, those probabilities would place the current recovery well into record territory. That raises the question: Could it be that the four-year business cycle has finally been repealed?
No, The Business Cycle Has Not Been Repealed!
Why is this important? First, there is a rhythm to typical business activity that has repeated continuously since the beginning of the industrial revolution over 150 years ago. Second, the ideal asset allocation and sector rotation for investment portfolios can be adjusted based on the stage of the business cycle. This effort can increase investor returns while reducing risks. The business cycle investment process, similar to the continually changing seasons, follows a logical sequence to make active asset allocation decisions. As sub advisors with over 40 years making disciplined investment decisions for clients based on business cycle changes, we have to admit that the repeal of the business cycle would put us in a bad place! Fortunately for our methodology, there are two reasons why repeal is not likely to happen. First, economic decisions are often made for emotional reasons, which are strongly motivated by fear and greed at business cycle turning points. In fact, the investment management team at our Walnut Creek office often like to say: “The stock market is nothing more than fear and greed super-imposed upon the business cycle.” History is respite with examples of people and economic sectors overextending themselves and suffering the consequences. So, repealing the business cycle would therefore be tantamount to repealing human nature—not likely!
Growth Slowdowns vs. Recession
The other reason lies in the fact that the cycle has actually been operating normally since 2009. Instead of experiencing an actual contraction in business activity though, the US economy transitioned through two separate growth slowdowns. That’s exactly what happened in the 1960’s and 1990’s, both of which experienced a couple of mid-stream slowdowns.
The big benefit of a growth slowdown, is that it is a cathartic experience preventing the economy from overheating. It also allows it to re-group for further gains. This process is not unlike a pit stop in a car race. Such an environment is also associated with a mini-bear market in stocks, where prices drop between 10-20% or experience a multi-month trading range. That compares to a “real” bear, where a 30-50% drop is more likely when an actual business contraction is in the air. The result in the 1960’s,1990’s as well as the 2009-18 period, was a long-term uptrend separated by mini-bears. That tempered economic activity resulted in three secular bull markets.