Monday, August 31, 2015

It’s the Economy, Smarty

As the old joke goes, economists have successfully predicted 9 of the last 5 recessions—and the stock market probably more. If you have clients worried about the U.S. sinking into economic quicksand, tell them to turn off the news, look at the facts and stay disciplined about their long term objectives.

Sure, the markets dropped 10 percent over 5 recent trading days between August 17 and 24. Statistically experts say that qualifies as a “correction” which can be either healthy or foreboding depending on your point of view. According to Yardeni Research, there have been almost 30 corrections of 10-plus percent since 1950, but not always followed by a bear market or economic recession.

We’re not in the financial advisory business, but many of you who are, have assured us that last week’s market volatility is little more than long overdue waves in a long stretch of smooth sailing.

Last time we checked, equities were still considered “risk assets,” not T-Bills, so there are going to be some ups and downs from time to time. “Even though people are asking themselves if prices are too high, they are slow to take action to sell,” explained renowned Yale Economics Professor, Robert Shiller, in a thoughtful piece in yesterday’s New York Times. But “when prices make a sudden drop, as they did in recent days, people tend to become fearful, even if there is a subsequent rebound. They suddenly realize their views might be shared by other people and start looking for information that might confirm belief,” added Shiller.

Makes sense. But, as William Dudley, president of the Federal Reserve Bank of New York opined last week, “The stock market has to move a lot—and stay there—to have implications for the U.S. economy.”

Case in point. The Commerce Department said late last week that durable orders rose a healthy 2 percent in July on top of recent increases in U.S. consumer confidence and new home sales. That’s a sign the U.S. economy is at least reasonably healthy and solidly expanding. That tends not to be when recessions occur, or true market corrections. If nothing else, take a step back and reflect. Most major market indices right now are pretty much at the same level they were heading into Labor Day weekend a year ago. Not a substantial return, but hardly bear market territory.

Millennials' impact on the economy

If that’s not enough, Bill Smead, who manages the Smead Value Fund
pointed out Friday that there are 86 million people in this country between the ages of 19 and 37. They don’t own stocks, they do drive cars, and they want to buy a house. This is nirvana for “them” said Smead, because they haven’t lost any money in the market, gas prices are plunging and mortgage rates are likely to remain low. All of which is great for the economy.

Need more? Last Thursday, the Commerce Department announced that our nation’s economy expanded at a faster pace than initially thought in the second quarter as businesses ramped up investment. Gross domestic product, the broadest sum of goods and services produced across the economy, expanded at a 3.7 percent seasonally adjusted annual rate in the second quarter of 2015, the Commerce Department said Thursday, up from the initial estimate of 2.3 percent growth.

Still not convinced? Well, the latest figures on business investment—reflecting spending on construction, equipment, and research and development—are especially welcome. The category rose at a 3.2 percent pace, compared with an earlier estimate of a 0.6 percent decline, suggesting a degree of optimism about future demand. Corporate profits after tax, without inventory valuation and capital consumption adjustments, rose at a 5.1 percent pace from the first quarter, the biggest jump in a year. On a year-over-year basis, corporate profit growth was 7.3 percent. As Business Insider’s Elena Holodny noted last Tuesday, the risk of markets plunging dramatically again in the short term are quite low without “certain economic conditions being met.”

John Higgin or Capital Economics noted that "Major declines in the S&P 500 — that is to say, bear markets in which prices drop by at least 20 percent, which is roughly twice the drop that occurred between 10th and 24th August — have only tended to occur in, and around, recessions. And we doubt very much that one of those is around the corner." 

Since 1950, the US has seen 9 bear markets and 10 recessions. And almost all of these bear markets have overlapped with the economic downturns. The one notable exception was October 1987's infamous "Black Monday" when the Dow plunged a shocking 508 points — or about 22.6 percent. Although stocks were in a bear market, GDP never went negative.

In light of that, Higgins pointed out that the even with the recent stock plunge, the US economy is currently looking pretty good. GDP growth expected to be around 2.3 percent this year, and 2.8 percent in the next, and policymakers are (still) considering hiking rates this year.

Finally, blogger Ben Carlson, CFA indicated that investing during periods of unrest usually pays off for investors. Three years out from a recession the annual returns showed an average annual gain of 11.9 percent, according to Carlson. Five years out the average annual gain was 12.3 percent. Only one time since 1957 was the stock market down a year later following a recession, which occurred during the 2000-2002 bear market.

During the actual recessions themselves the total returns look much worse as they were negative, on average (-1.5 percent annually).  But this average is made up of a wide range in results, as stocks have actually risen during 4 out of the last 9 recessions. And stocks were positive 6 out of the past 9 times in the year leading up to the start of a recession, dispelling the myth that the stock market always acts as a leading indicator of economic activity.


Bottom line, there’s no reason to make any hasty or dramatic changes to your investing or business expansion plans, and there are bargains to be had if your risk tolerance and time horizon allows you to explore those opportunities right now. Even Shiller, whose widely followed CAPE (Cyclically Adjusted Price Earnings) ratio signals that stock prices are dangerously overpriced admits we’re in a “rare and anxious “just don’t know” situation.

blog has more about this and related topics.

TAGS: economy and stock market correlation, risk of recession, bear market, investor discipline, business investment, Shiller CAPE, William Dudley, Bill Smead, Ben Carlson CFA

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