A perspective from E*TRADE Capital Management, LLC
The United States has seen 33 full business cycles since 1854—a period marked by industrialization, urbanization, and the advent of a modern, market-based economy.1 While flounces and frock coats have given way to leggings and skinny jeans, some things have remained remarkably consistent during this period, including the nature of business cycles. As sure as the economy grows, it will inevitably contract.
So, where are we today? On any given day you might hear that the economy is boiling hot or that a recession looms. Pinpointing just when a business cycle has peaked seems as likely as finding a Whig Party thread on Instagram—however, there are signals out there.
What constitutes a recession?
Generally speaking, economists define a recession as two consecutive quarters of declining gross domestic product. As is the norm with matters of the economy, however, opinions differ. A more nuanced version is provided by the Business Cycle Dating Committee of the National Bureau of Economic Research—no doubt a real collection of social cutups—which defines a recession as a “significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income and wholesale/retail trade.”2
What the arbiters of business cycles agree on is that all periods not marked by recession are defined as economic expansion. This has been the normal state of the economy throughout US history—in fact, most economic expansions have lasted more than three years, while most recessions have lasted no more than 18 months.3 The period spanning March 1991 through March 2001 remains the longest US expansion on record, and we are now in the second-longest expansion, which can be traced to June 2009.1
What do leading indicators say about the current business cycle?
So we know we’re in an expansionary period, but when will it peak? Just where are we in the current business cycle?
We can take signals from leading indicators—data points that tend to lead various phases of the business cycle. The major stock indexes are some of the most-watched leading indicators, because they have historically shown signs of weakness well ahead of inflections in the economy.
Some leading economic indicators
Economists track a wide array of leading economic indicators. Here are just some of them:
1. Stock prices
2. Building permits
3. Average weekly manufacturing hours
4. Non-defense capital goods orders
5. Average weekly claims for unemployment insurance
If these seem like an unwieldy bunch of stats, you’re in luck: A group known as the Conference Board has done the heavy lifting for us. Ten leading economic indicators make up the Conference Board Leading Economic Index (LEI), which was up 0.2% in May according to a report released last week. This suggests that we may be approaching a late-growth stage of the current business cycle, sometimes known as “late cycle.” According to the Conference Board’s most recent statement, “The U.S. LEI still points to solid growth but the current trend, which is moderating, indicates that economic activity is not likely to accelerate.”3
The LEI isn’t the only clue that the current business cycle is getting long in the tooth. Typically in a late-cycle economy, stock valuations are rich and signs of inflation begin to emerge. Already, the Federal Reserve has indicated that inflation is near its 2% target, while the forward price-to-earnings ratio for the S&P 500 Index is at 16.45.4 For comparison, in late 2001, that ratio was hovering just above 10.00. While there is likely still room to run in the current business cycle, it may not be too early to consider strategies for a late-cycle economy.
Potential late-stage strategies
Here are a few strategies that some market participants might gravitate toward in late-cycle stages of the economy:
1. High-quality large-cap stocks tend to be associated with companies with stable earnings that can withstand economic fluctuations. (Of course, performance is relative. While blue chips may outperform other asset classes at a given time, they can still lose value.)
In terms of sectors, consumer staples, energy, and health care stocks have tended to perform well late in the business cycle, when manufacturing activity is still strong, but off from its peak.
2. Commodities and Treasury Inflation-Protected Securities (TIPS) can serve as a hedge against inflation, which has so far been contained, but could inch upward in a late-growth period.
3. Investment-grade bonds generally come with less risk than high-yield bonds and may carry less default risk in the event of economic deceleration. The highest-quality coporates tend to be the most conservative plays within this asset class.
The equity markets bear watching because stocks are a reflection of investor expectations. But investors are not immune from behavioral biases and acting on emotion. For this reason, the markets—and leading indicators as a whole—can serve as useful guideposts, but should not be used as precise predictive tools.
The business cycle is part of the ebb and flow of investing. This is why diversification is so important, since it helps investors navigate the market’s ups and downs. Whatever one’s outlook on the economy, investors should not lose track of their long-term financial goals, which remain the best determinants of an overarching investment strategy.
1. The National Bureau of Economic Research, “US Business Cycle Expansions and Contractions,” http://www.nber.org/cycles.html
2. The National Bureau of Economic Research, “The Business-Cycle Peak of March 2001,” http://www.nber.org/cycles/november2001/
3. The Conference Board, “Global Business Cycle Indicators,” https://www.conference-board.org/data/bcicountry.cfm?cid=1
4. FactSet Data Systems, June 25, 2018