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On March 21, 2007, the UK Chancellor of the Exchequer, Gordon Brown, told Britain’s House of Commons that the economy would see “no return to the old boom and bust.”
Three months later, Brown succeeded Tony Blair as Prime Minister. And in May 2008, the UK economy slipped into its worst economic and housing bust since the 1930s.
Major economies have endured alternating periods of expansions and contractions for centuries; governments and central banks can’t abolish the business cycle.
According to the National Bureau of Economic Research—the official arbiter of US business cycles—America has suffered 33 recessions since 1854. The longest period of US economic expansion stretched from March 1991 to March 2001, while the longest contraction lasted a whopping 65 months between 1873 and 1879.
Economic cycles have major implications for stocks, bonds, commodities and other markets.
We define bear markets for the S&P 500 as any decline from intraday peak to trough of 20 percent or more. Since 1960, US stocks have endured 12 bear markets. These periods of extended weakness have an average duration of a little more than a year and a mean decline of 32 percent.
A US recession has accompanied seven of the 12 bear markets in our study. Market downturns that coincide with a recession tend to be longer and more severe, lasting an average of 72 weeks and resulting in a decline of almost 40 percent for the S&P 500.
Many of the bear markets that have occurred during periods of US economic expansion are marginal. Examples include the S&P 500’s almost 22 percent decline in 2011 and a roughly 20 percent pullback between 1976 and 1978.
The US economy exited the so-called Great Recession about 53 months ago. With the average postwar expansion lasting 58.4 months, this simple logic would suggest that the odds favor another recession within the next 12 to 24 months.
Meanwhile, the S&P 500’s last 20 percent pullback occurred 160 weeks ago—within range of the average duration of the postwar bull market—suggesting that, at the very least, the rally in US equities looks long in the tooth.
Several other technical factors point to the possibility of a new bear market emerging over the next 12 to 24 months.
As a rule, the S&P Small-Cap 600 Index tends to top out before the broader market.
For example, this index hit a pre-crisis high on July 17, 2007—almost three months before the S&P 500 topped out on Oct. 11.
Similarly, the S&P Small-Cap 600 reached an all-time high on July 1, 2014, while the S&P 500 hit its record high in September.
After a short-lived correction, the S&P 500 looks poised to make new highs, while the small-cap index still sits 2.5 percent off its July 2014 peak.
However, this relationship is far from infallible. Small-capitalization stocks don’t always lead the broader market, nor does a bout of underperformance for this market segment necessarily translate into a bear market.
For example, the S&P Small-Cap 600 rallied through most of 2000 and 2001, while the tech bust meant that the S&P 500 endured a pummeling.
As bull markets grow long in the teeth, more and more pundits call for stocks and the economy to enter their inevitable down-cycle. Like a broken-clock, these commentators eventually will be right.
However, these alarmists rarely make money for investors; historically, there’s little reward for picking the market’s exact top.
For the 12 postwar downturns in our study, we calculated the total return earned by investors who sold the S&P 500 three months before and three months after the inflection point between a bull and bear market. We also eliminated the three bear markets that lasted less than six months.
On average, early-bird investors who bailed out of their stock holdings three months ahead of a market top saved their portfolios from a 26.8 percent decline; those who waited three months to sell their stocks avoided a 25.4 percent loss.
Bottom Line: Commentators who constantly pontificate about a pending bear market or stock market crash don’t add much value.
Instead, investors worried about a major pullback would be better off waiting for real evidence of economic softness to emerge.
Although the length of the current economic expansion and bull market suggest that we should be vigilant, our trusted indicators continue to point toward more upside for the S&P 500 into early 2015.
The US economy grew at a 3.5 percent annualized pace in the third quarter and appears to be on track to expand by 3 percent in 2015. If this momentum continues, US gross domestic product (GDP) would expand at the fastest annual rate in a decade.
My favorite forward-looking metric, the Conference Board’s index of Leading Economic Indicators (LEI), encapsulates the performance of 10 data points that tend to fall before the US enters a recession.
A negative year-over-year change in LEI has reliably warned of an impending recession since the late 1950s. On that basis, the economy appears to be on sound footing: This metric has increased steadily since early 2013, and in August 2014 climbed 6.8 percent from year-ago levels.
(Click graph to enlarge.)In addition to the year-over-year change in LEI, we also pay close attention to the index’s monthly movements. Historically, four sequential declines in LEI readings signal an elevated risk that the US will slip into recession over the next 12 months.
But with the exception of a negative month-over-month reading in January—an anomaly associated with the polar vortex—LEI has increased sequentially in every month since March 2013.
Because the worst market downturns often coincide with a US recession, we’d need to see a more meaningful downturn in LEI before we become overly concerned about the stock market.
Of course, other risks could sour investor sentiment. Weakness in other major economies appears to be the biggest threat.
Check out this graph of the Purchasing Managers Index for the EU manufacturing sector, a popular indicator where readings less than 50 correspond to a contraction in economic activity and values of 46 or less often indicate a recession.
Although PMI readings in the EU haven’t slipped to levels that would presage an imminent downturn, France—the second-largest economy in the eurozone—appears to be on the verge of recession. And Germany’s PMI has trended lower in recent months, even dipping below 50 during the summer.
As my colleague Yiannis Mostrous points out in Japan: The Big Bet, the world’s third-largest economy continues to struggle with deflation despite the government’s herculean effort to stimulate growth via quantitative easing.
The Bank of Japan’s surprise decision to expand its annual asset purchases to JPY80 trillion (about US$750 billion) from JPY60 trillion to JPY70 trillion sent the Nikkei Index soaring last Friday. However, investors should remember that longer-term structural reforms promised by Prime Minister Shinzo Abe will be critical to promoting sustainable economic growth.
In other words, there’s a risk that slowing GDP growth in Europe, Japan and key emerging markets could weigh on the rate at which the US economy expands.
However, the global economy stands to benefit from the recent drop in oil prices; as a rule of thumb, global GDP increases by about 0.5 percent for every $10 per barrel decline in Brent crude, a widely watched international price benchmark.
In recent years, the US economy has received a welcome boost from the growing abundance of domestically produced oil and natural gas, an advantage that has reduced households’ heating bills and fueled a boom in manufacturing activity. (See America’s Energy Advantage and The US Economy’s Energy-Security Blanket.)
And despite all the talk about rising interest rates and the Federal Reserve ending its bond-buying program, fixed-income securities have been on a tear this year.
The yield on 10-year Treasury bonds has slipped to less than 2.4 percent from 3 percent at the start of 2014, while the average 10-year BBB-rated US corporate bond yields only 3.85 percent today—compared to more than 4.6 percent at the year’s outset.
Bottom Line: Economic fundamentals suggest that calls for the bull market to end look premature.
In Capitalist Times Premium, the Wealth Builders Portfolio has retained its exposure to cyclical stocks—a positioning that continues to pay off.
We’ll keep a close eye on LEI and other key indicators for a signal that economic growth is falteringbefore we assume a more defensive stance.