Watch These Two Market Indicators
While a roaring economy typically rewards equity investors, the GDP growth rate in the U.S. has continued to grow at that same 2.2% pace that we have seen since the recovery began in March 2009. When you compare that to the GDP growth rates of past economic expansions, some may classify the current growth rate as “sub par”. As in the tale of the
While a roaring economy typically rewards equity investors, the GDP growth rate in the U.S. has continued to grow at that same 2.2% pace that we have seen since the recovery began in March 2009. When you compare that to the GDP growth rates of past economic expansions, some may classify the current growth rate as “sub par”. As in the tale of the tortoise and the hare, sometimes slow and steady wins the race.
The number one questions on investor’s minds: “It’s been a great rally but are we close to the end?” Referencing the chart below, if you look at the length of the current economic expansion, going back to 1900 we are now witnessing the 3rd longest economic expansion on record which is making investors nervous because as we all know that markets work in cycles.
However, if you ignore the “length” of the rally for a moment and look at the “magnitude” of the rally it would seem that total GDP growth of the current economic expansion has been relatively tame compared to some of the economic recoveries in the past. See the chart below. The chart shows evidence that there have been economic rallies in the past that were shorter in duration but greater in magnitude. This may indicate that we still have further to go in the current economic expansion.
What causes big rallies to end?
Looking back at strong economic rallies in the past, the rallies did not die of old age but rather there was an event that triggered the next recession. So we have to be able identify trends within the economic data that would suggest that the economic expansion has ended and it will lead to the next recession.
Watch these two indicators
Two of the main indicators that we monitor to determine where we are in the current economic cycle are the Leading Indicators Index and the Yield Curve. History rarely repeats itself but it does rhyme. Look at the chart of the leading indicators index below. The leading indicators index is comprised of multiple economic indicators that are considered “forward looking”, like housing permits. If there are a lot of housing permits being issues, then demand for housing must be strong, and a strong housing market could lead to further economic growth. Look specifically at 2006. The leading indicators went negative in 2006, over a year before the stock market peaked in 2007. This indicator was telling us there was a problem before a majority of investors realized that we were on the doorstep of the recession.
Let’s look at the second key indicator, the yield curve. You will hear a lot about the “slope of the yield curve” in the media. In a healthy economy, long term interest rates are typically higher than short term rates which results in a “positively slopped” yield curve. In other words, when you go to the bank and you have the choice of buying a 2 year CD or a 10 year CD, you would expect to receive a higher interest rate on the 10 year CD because they are locking up your money for 10 years instead of 2.
There are periods of time where the interest rate on a 10 year government bond will drop below the interest rate on a 2 year government bond which is considered an “inverted yield curve”. Why does this happen and why would investors by that 10 year bond that is yielding less than the 2 year bond? This happens because bond investors are predicting an economic slowdown in the foreseeable future. They want to lock in the current 10 year interest rate knowing that if the economy goes into a recession that the Fed may begin to lower the Fed Funds Rate which has a more rapid impact on short term rates. It’s a bet that the 2 year bond rate will drop below the 10 year bond rate within the next few years.
If you look at the historical chart of the yield curve above, the yield curve inverted prior to the recession in the early 2000’s and prior to the 2008 recession.
Looking at where we sit today, within the last 6 months the leading indicators index has not only been positive but it’s accelerating and the yield curve is still positively sloped. While we realize that there is not a single indicator that accurately predicts the end of a market cycle, these particular economic indicators have historically been helpful in predicting danger ahead.
There will always be uncertainty in the world. Currently it has taken the form of U.S, politics, tax reforms, geopolitical events, and global monetary policy but it would seem that based on the hard economic data here in the U.S. that our economic expansion that began in March 2009 may still have further to go.
About Michael.........
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Where Are We In The Market Cycle?
Before you can determine where you are going, you first have to know where you are now. Seems like a simple concept. A similar approach is taken when we are developing the investment strategy for our client portfolios. The question more specifically that we are trying to answer is “where are we at in the market cycle?” Is there more upside
Before you can determine where you are going, you first have to know where you are now. Seems like a simple concept. A similar approach is taken when we are developing the investment strategy for our client portfolios. The question more specifically that we are trying to answer is “where are we at in the market cycle?” Is there more upside to the market? Is there a downturn coming? No one knows for sure and there is no single market indicator that has proven to be an accurate predicator of future market trends. Instead, we have to collect data on multiple macroeconomic indicators and attempt to plot where we are in the current market cycle. Here is a snapshot of where we are at now:
The length of the current bull market is starting to worry some investors. Living through the tech bubble and the 2008 recession, those were healthy reminders that markets do not always go up. We are currently in the 87th month of the expansion which is the 4th longest on record. Since 1900, the average economic expansion has lasted 46 months. This leaves many investors questioning, “is the bull market rally about to end?” We are actually less concerned about the “duration” of the expansion. We prefer to look at the “magnitude” of the expansion. This recovery has been different. In most economic recoveries the market grows rapidly following a recession. If you look at the magnitude of this expansion that started in the 4th quarter of 2007 versus previous expansions, it has been lackluster at best. See the chart on the next page. This may lead investors to conclude that there is more to the current economic expansion.
Next up, employment. Over the past 50 years, the unemployment rate has averaged 6.2%. We are currently sitting at an unemployment rate of 5.0%. Based on that number it may be reasonable to conclude that we are close to full employment. Once you get close to full employment you begin to lose that surge in growth that the economy receives from adding 250,000+ jobs per month. It may also imply that we are getting closer to the end of this market cycle.
Now let’s look at the valuation levels in the stock market. In other words, in general are the stocks in the S&P 500 Index cheap to buy, fairly valued, or expensive to buy at this point? We measure this by the forward price to earning ratio (P/E) of the S&P 500 index. The average P/E of the S&P 500 over the last 25 years is 15.9. Back in 2008, the P/E of the S&P 500 was around 9.0. From a valuation standpoint, back in 2008, stocks were very cheap to buy. When stocks are cheap, investors tend to hold them regardless of what’s happening in the global economy with the hopes that they will at least become “fairly valued” at some point in the future. Right now the P/E Ratio of the S&P 500 Index is about 16.8 which is above the 15.9 historic average. This may indicate that stock are starting to become “expensive” from a valuation standpoint and investors may be tempted to sell positions during periods of volatility.
Even though stocks may be perceived as “overvalued” that does not necessarily mean they are not going to become more overvalued from here. In fact, often times after long bull rallies “the plane will overshoot the runway”. However, it does typically mean that big gains are harder to come by since a large amount of the future earnings expectations of the S&P 500 companies are already baked into the stock price. It leaves the door open for more quarterly earning disappointments which could rise to higher levels of volatility in the markets.
The most popular question of the year goes to: “Trump or Hillary? And how will the outcome impact the stock market?” I try not to get too deep in the weeds of politics mainly because history has shown us that there is no clear evidence whether the economy fares better under a Republican president or a Democratic president. However, here is the key point. Markets do not like uncertainty and one of the candidates that is running (I will let you guess which one) represents a tremendous amount of uncertainty regarding the actions that they may take if elected president of the United States. Still, under these circumstances, it is very difficult to develop a sound investment strategy centered around political outcomes that may or may not happen. We really have to “wait and see” in this case.
Let’s travel over the Atlantic. Brexit was a shock to the stock market over the summer but the long term ramifications of the United Kingdom’s exit from the European Union is yet to be known. The exit process will most likely take a number of years as the EU and the UK negotiate terms. In our view, this does not pose an immediate threat to the global economy but it will represent an ongoing element of uncertainty as the EU continues to restart sustainable economic growth in the region.
The chart below is one of the most important illustrations that allows us to gauge the overall level of risk that exists in the global economy. When a country wants to jump start its economy it will often lower the reserve rate (similar to our Fed Funds Rate) in an effort to encourage lending. An increase in borrowing hopefully leads to an increase in consumer spending and economic growth. Unfortunately, countries around the globed have taken this concept to an extreme level and have implemented “negative rates”. If you buy a 10 year government bond in Germany or Japan, you are guaranteed to lose money over that 10 year period. If you have a checking account at a bank in Japan, instead of receiving interest from the bank, the bank may charge you a fee to hold onto your own money. Crazy right? It’s happening. In fact, 33% of the countries around the world have a negative yield on their 10 year government bond. See the chart below. When you look around the globe 71% of the countries have a 10 year government bond yield below 1%. The U.S. 10 Year Treasury sits just above that at 1.7%.
So, what does that mean for the global economy? Basically, countries around the world are starving for economic growth and everyone is trying to jump start their economy at the same time. Possible outcomes? On the positive side, the stage is set for growth. There is “cheap money” and favorable interest rates at levels that we have never seen before in history. Meaning a little growth could go a long ways.
On the negative side, these central banks around the global are pretty much out of ammunition. They have fired every arrow that they have at this point to prevent their economy from contracting. If they cannot get their economy to grow and begin to normalize rates in the near future, when they get hit by the next recession they will have nothing to combat it with. It’s like the fire department showing up to a house fire with no water in the truck. The U.S. is not immune to this situation. Everyone wants the Fed to either not raise rates or raise rates slowly for the fear of the negative impact that it may have on the stock market or the value of the dollar. But would you rather take a little pain now or wait for the next recession to hit and have no way to stop the economy from contracting? It seems like a risky game.
When we look at all of these economic factors as a whole it suggests to us that the U.S. economy is continuing to grow but at a slower pace than a year ago. The data leads us to believe that we may be entering the later stages of the recent bull market rally and that now is a prudent time to revisit the level of exposure to risk assets in our client portfolios. At this point we are more concerned about entering a period of long term stagnation as opposed to a recession. With the rate of economic growth slowing here in the U.S. and the rich valuations already baked into the stock market, we could be entering a period of muted returns from both the stock and bond market. It is important that investors establish a realistic view of where we are in the economic cycle and adjust their return expectations accordingly.
As always, please feel free to contact me if you’d like to discuss your portfolio or our outlook for the economy.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
