Any time the stock market gets scary – as it has in the past couple of weeks – I like to fall back on a strong, rational, data-driven understanding of exactly where we stand economically. This practice helps me see what really matters – the overall economy. Remember, the economy is largely rational, while the stock market is the economy plus emotions.
So, there can be a huge difference between what’s happening in the economy and what’s happening in the market. That’s because, while the stock market is influenced by hard data, it is also hugely driven by investors’ emotions. At any given time, the stock market can run ahead of the economy or behind it, but it rarely trades precisely on pace.
There are dozens of dozens of different datasets that make up and influence the overall economy. I have identified 12 major subsets of the economy that I look to when formulating an objective opinion about how we’re really doing. Each of these 12 categories works on somewhat different schedules, but all need to be considered to bring the big economic picture into focus.
These subsets are Labor; Monetary Policy; Credit; Profits; Automobiles; Housing; Commercial Real Estate; Energy; Capital Spending; Trade and Current Account; Fiscal Policy; and Demographics. We’ll dive into each a bit later.
First, let’s talk about what we just experienced and apply some good ol’ fashioned rational perspective to try to understand what it means for us going forward.
Here we are, after a 6% – 7% stock selloff that happened in what felt like a flash. Sure, we’ve had a strong economy over the past year – with growth in the 3.5% range for 2018 – but it’s hard to feel like everything is sunshine and roses after something this shocking. Here’s where it pays to remember that the economy is not the stock market and the two don’t always move in lockstep.
I believe this is exactly what we’re seeing here.
We had terrible stock market performance last week, but the economy is still exceptionally strong. The unemployment rate is under 4% (the lowest since 1969); wage inflation is at a healthy 2.8%; manufacturing is expanding; US nonmanufacturing activity is at the highest level on record; consumer sentiment is strong; consumer spending is strong. Our list goes on.
Now, you may be thinking, “So what, Wes. That could all end tomorrow, and we could go back into recession at the drop of a hat. Right?”
My answer is: Not so fast – that’s not the way it works. Economic expansions don’t just get tired and stop. Something has to happen to trigger it. And that “something” has to be some creation of an excess that then corrects itself.
For example, in 2006-2007, we saw over-lending by banks, over-borrowing and excessive credit extended to the wrong borrowers; these were dramatic imbalances. This practice created over-economic expansion, like an engine running too hot. Then, when the imbalances stopped and corrected in the opposite direction, excess money and stimulus dried up, and the entire economy reversed.
To this point, expansions wither up when excess and imbalance come on the economic scene and then whiplash into correction. They dry up when we get tight financial conditions and when we get major shocks – like the price of oil spiking to $150 per barrel.
Where are we in the current economic cycle? I’m glad you asked.
By definition, economic cycles begin at a “trough,” or low point. Then, the cycle comes out of recession, goes into expansion where it eventually peaks, and then heads back into another trough. But what we care about now is, when will this expansion end?
Let’s start at the end. To answer the question of where we are now, there’s no better analogy than football.
We are not near the end of the game. This isn’t the two-minute warning. Heck, it’s not even the fourth quarter yet. From all of our indicators, we’re in the middle to late third quarter.
What does this look like in real time? It looks like beyond 2019, beyond 2020, or even later…
Here are a few important points to remember as we consider the life-cycle of this current expansion:
1. While we are in the second-longest expansion of all time, we are far from the strongest. This fact suggests we have additional time left in the game.
2. Looking at various subcycles takes both objectivity and subjectivity – it’s not exactly all black and white. And, each subcycle doesn’t move in perfectly predictable patterns. So, this, of course, requires that we look at the totality of the data.
3. When we look at these subcycles, we see that there are no massive imbalances or over-reaching excesses.
4. Yes, all of this could change. But, with where we are now, these economic subcycles taken together point to us being in the third quarter of a football game, and, in real time, that’s 2019 or 2020.
5. Another way of evaluating our expansion is in terms of the amount of real GDP created. If this were a typical post-war expansion – lasting five years and growing 4.6% per year – real GDP would have increased by 25%. At 22.3% so far, this expansion is relatively mediocre. Our 22.3% GDP growth is only half of the powerful 1960s boom and is far below the 43% of the 1990s.
6. Where are we in the subsets of the economy?
- Labor – Late
- Monetary Policy – Post-Midpoint
- Credit – Post-Midpoint
- Profits – Late
- Auto – Very Late
- Housing – Pre-Midpoint
- Commercial Real Estate – Post-Midpoint
- Energy – Pre-Midpoint
- Capital Spending – Late
- Trade and Current Account – Pre-Midpoint
- Fiscal Policy – Pre-Midpoint
- Demographics – Early
As you can see from above, we’re only clocking in at late in the cycle in the subsets of Labor, Corporate Earnings, Autos, and Capital Spending. The rest of our list – eight out of 12 – are either at the midpoint or in early growth stages.
For example, Housing still looks like it has a way to go before peaking. There’s actually a housing shortage, but still, we don’t have over-building. The shortage probably won’t be eliminated anytime soon. Analysis of the supply and demand for housing in 2018 shows a shortage of 1.4 million units. From this reality, the current cycle seems like it has much further to go yet.
As for Commercial Real Estate, we’ve had a pretty tepid last two years in terms of price appreciation. Occupancy rates are high, but, again, there has not been overbuilding. It may not look like it in your city (Atlanta, I’m looking at you), but as a whole, the US has not seen excess in buildings cropping up.
Turning to Fiscal Policy, tax cuts just began in 2018, and haven’t fully kicked in yet. The Congressional Budget Office (which is usually ultra-conservative in estimates and undershoots) says expansion will last until 2022, just before the sunset provision kicks in. I doubt we’ll see a sunset, but agree that expansion still has some life left in it yet.
And, Demographics clock in as being in the early-early cycle. Remember “MY Ratio?” This data point is the ratio of middle-aged (M) to younger adults (Y) and has been an effective predictor of secular stock market trends. When there are more middle-aged adults in the US versus young adults, this generally leads to an acceleration in consumer spending. The MY ratio peaked in 2000-01 in parallel with the equity market. Projections now show the ratio continuing to rise until 2021, and then turning higher before topping out in the mid-2030s.
Our Bottom Line
We seem to be a long way off from heading back into recession. My belief is that we’re in the third quarter, not the fourth quarter and certainly not facing the two-minute warning. The economic consensus is that we won’t see a recession until possibly 2020. And, we may stave off “the R-word” for longer than that.
This doesn’t mean stocks will be gangbusters until 2020 or 2021. (Remember, the economy plus emotion.) But it does mean that the economy will be serving as a tailwind for stocks until the recession winds change.
The economy befuddles even economists. But I enjoy closely tracking the economy – so much so that I majored in economics and made a career in financial management. If you ever need help wending your way through the shifting economic and market winds, you can always give us a ring. Until then, enjoy the game!
