Last week I penned an article that looked at "The Great Moderation," a term coined by economists to describe a period of lower economic volatility that occurred from the mid 1980s to the early 2000s. During this period recessions were fewer in occurrence than in the preceding decades and were also shorter in duration as well as milder in magnitude. One of the main reasons behind this development was the maniacal credit growth so prevalent from the 1980s to 2007. A high and persistent debt growth rate prolonged the business cycle from the traditional 3-4 year cycle to an 8-10 year cycle, and along with it propelled the stock market to ridiculously expensive levels during the technology bubble of 2000 and housing price thereafter. All of this is changing and we should expect greater economic and stock market volatility for the next few years as we return back to a normal business and stock market cycle that lasts on average 3-4 years.
There are two economic bodies in the U.S. that have developed leading economic indicators that are models that predict what the future trend in economic growth will be, with these indicators doing a fairly good job in predicting economic contractions and expansions well ahead of the actual GDP numbers. One economic group is the Conference Board and the other is the Economic Cycle Research Institute (ECRI). Lakshman Achuthan, managing director of the ECRI was recently on Yahoo’s Tech Ticker and did a series of three videos in which he shared his thoughts on the current economic and future outlook. Mr. Achuthan supports our view that the U.S. is going to return to a normal business cycle and people should expect more recessions to come this decade. A link to the first interview and an excerpt from the Yahoo Tech Ticker article is provide below (emphasis added).
More "Boom and Bust" Cycles Coming: The Real Reason Buy and Hold Is Dead
"I'm not saying 'buy and hold' is a bad thing, unless you're having more frequent recessions," he says. And that is precisely what ECRI expects in the coming decade because of two big patterns that Achuthan says are irreversible:
- One, successive recoveries from post WWII recessions have become weaker and weaker "on every count," including growth, sales, employment and production.
- Two, there's more volatility in the economy, with the big swoon in late 2008-early 2009 and surge in more recent months being a glaring example.
Achuthan predicts we have entered a period of "more ‘boom and bust'-type cycles," similar to what occurred in the 1970s. "The Great Moderation is history," he says, referring to the period starting in the mid-1990s when many economists (and policymakers like Ben Bernanke) believed the business cycle had been smoothed out, if not eradicated.
"You don't have to be a mad scientist," he says; just "back off your risk in the stock market and buy bonds" if a recession appears imminent. "And if we see a recovery take more exposure and get out of bonds because the recovery is going to give you a little inflation."
I could not agree more with Mr. Achuthan. As the business cycle has shifted so too must one’s investment strategy. In a prolonged business and stock market cycle such as the 1980s and 1990s, a buy-and-hold strategy works best. However, when economic and stock market volatility picks up a more profitable strategy involves taking gains off the table to sidestep bear markets as the economy enters into a recession and go into bonds, and then switch out of bonds and back into stocks when a new recovery begins. Like Achuthan I believe we are in a period similar to the 1970s and, as seen below, the 1970s were not good years for stocks which virtually traded sideways for more than a decade with huge price swings as the economy moved in and out of a recession. While the Dow virtually traded sideways for more than a decade, you can see above that there were sharp rallies and sell offs that provided sizable trading opportunities for a more nimble investor than the pure buy and hold strategy.
Source: Bloomberg
If the ECRI and I are correct in believing that we are in a period similar to the 1970s, then watching the leading economic indicators and practicing risk management will be crucial ahead. The ECRI calls their leading economic indicator the weekly leading index (WLI), and you can see below how well the WLI tracks the year-over-year growth rate in real GDP. During the 1970s the WLI would turn down ahead of a coming recession and provided an early warning for investors that a recession approached.
Source: ECRI, BEA
When the WLI would roll over the risk/reward profile of stocks versus bonds shifted towards favoring bonds. Even in the inflationary 1970s there were periods to be in bonds as no market moves in a linear fashion forever. When the stock market was too extended and the leading economic indicators rolled over, a profitable strategy would be to sell stocks and move to cash and/or buy bonds. When the leading economic indicators dipped into negative territory and then reversed course was the time to sell bonds and then reenter the stock market. A useful indicator to help identify the asset allocation rotation between stocks and bonds is the 12-month relative performance of stocks versus bonds, which happens to correlate well with the leading economic indicators. When the leading economic indicators rolled over in conjunction with a turnaround in the stock-bond relative performance after reaching an extreme often marked ideal points of asset switching from stocks to bonds, and vice versa at negative extremes.
Source: Ned Davis Research
Right now you can see in the images above that the WLI has rolled over and the stock to bond relative performance has reached a major extreme and is also rolling over. What these indicators suggest is that the next six to nine months may favor more defensive asset classes as stocks cool off from their dramatic gains from last year. What we could see is that for a period of time stocks underperform bonds and defensive sectors like consumer staples, health care, telecommunications, and utilities outperform cyclical sectors like the consumer discretionary, financials, technology sectors. This would fit nicely with analysis I did earlier that suggests defensive sectors may outperform cyclical sectors over the next six months (Contrary Investing: Loving the Unloved).
Outperformance of defensive sectors and bonds relative to the broad stock market in addition to a rolling over of leading economic indicators does not necessarily point to a recession on the horizon. Some of the bearish newsletter writers and economists are pointing to the current decline in the leading economic indicators as a sign of a coming recession and bear market in stocks, though I disagree. When the leading economic indicators rolled over from lofty levels in 2004 a prolonged consolidation was the result, not another bear market and recession. In 2004 the leading economic indicators did roll over but they remained in positive territory and it wasn’t until the recent recession in 2007 that they turned negative. What we are likely to see ahead is a slowing in U.S. economic growth with this slowdown reflected in risk assets relative performance to defensive investments. Calling for a recession at this time appears to be premature as there isn’t enough evidence to support such a call. These observations are supported by the ECRI as highlighted below in the second and third Yahoo Tech Ticker interview and article with Mr. Achuthan.
As Red Hot Economy Cools, Stocks Face Midyear Challenge, ECRI's Achuthan Says
At some point something's gotta give: Either the economy is going to pick up steam again or the stock market is going to struggle. Expect the latter to occur, says Lakshman Achuthan, managing director of the Economic Cycle Research Institute (ECRI)…
As the economy tries to lift itself from the bottom, Achuthan advises not to mistake a lower growth rate as a precursor to another recession. Instead, a more likely scenario is a choppy 2010 for the economy and the market. "A lot of it depends also on the Fed and the inflation situation," he says; if inflation stays tame, the Fed will leave rates at zero for a longer period of time, which should be bullish for the stock market.
Growth May Slow But "There's No New Recession Anywhere in Sight"
The final revision is in, and the Commerce Department reported today that the U.S. economy officially grew at 5.6% pace in the fourth quarter of last year. However, as the Associated Press reports, many economists think that impressive growth will be cut in half this quarter.
Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) isn't so sure. He admits, "2010 looks a lot dicier than 2009." However, his data shows the business cycle is currently healthy. "The growth rate after tailing off from record, record highs, is now stabilizing and inching up," he says in the accompanying clip. In fact, the ECRI’s weekly leading index just hit a nine-week high.
And, as for a double-dip recession, Achuthan says it isn't in the cards. "There's no new recession anywhere in sight. In 2010, the business cycle remains your friend," he says with confidence.
Even so, ECRI's research does show a slowdown later in the year. "The weekly leading index is pointing to an easing in growth by mid year," he notes.
Again, I could not agree more with Mr. Achuthan from the ECRI. I expect the stock market will enter a corrective or consolidation period as we approach the summer as it works off its overbought condition and as the strong growth off the economic recessionary bottom of 2009 cools. I do not anticipate a recession in the near term as neither the WLI nor the recession probability model by Economics Professor Jeremy Piger from the University of Oregon (shown below) point to an approaching recession.
Source: Jeremy Piger, Professor of Economics, University of Oregon
Referring back to the secular bear market of the 1970s, one risk management tool that worked extremely well in getting investors out of the bulk of the bear markets during that period while also exposing them to the bulk of the bull markets was the weekly 15/40 exponential moving average (EMA) system on the S&P 500. To shorten the length of this article, rather than explaining the 15/40 EMA system I would like to refer readers to a previous article. A more in depth commentary and examples of how the 15/40 EMA system performed during the Great Depression and the 1970s can be found by reading the “There Are No Black Boxes, Just Tool Boxes” section near the bottom of a Market Observation article written earlier in the year, “The Guy behind the Guy Is You and I.”
Using risk indicators in conjunction with each other may help to weed out the noise and produce better signals, which is where the 15/40 EMA system can come in handy. One looking at the roll over of the ECRI WLI in 2004 may have thought we were heading into a recession rather than a slowdown, though the 15/40 weekly EMA system never generated a sell signal. Trend changes from extremes in the ECRI WLI confirmed with signal changes in the 15/40 EMA system will likely produce more accurate signals than relying on either indicator in isolation.
Summary
The stock market is presently overbought and we may have a short-term correction, though I believe the market will hit new highs later in the year given economic and stock market breadth remain solid (Breadth Supports Continuation of Bull Market), with defensive sectors likely playing catch up with the cyclical sectors as the leading economic indicators roll over.
While we may hit new highs in the stock market later in the year there will come a time that a more proactive investment approach will be warranted as I expect greater stock market and economic volatility this decade. Helpful tools for monitoring the risk during this heightened period of market and economic volatility will be the ECRI’s WLI, the stock to bond relative performance, as well as the weekly 15/40 EMA system to help navigate one’s portfolios through these choppy waters. As mentioned above, presently neither the WLI nor the 15/40 EMA on the S&P 500 are calling for a recession or major defensive positioning for a bear market.
