In Search of the Business Cycle

Currently in the midst of its eighth year, this bull market is the second longest on record. Conventional wisdom would suggest this puts us in the late stages of a traditional business cycle. The current cycle, however, has not followed the traditional pattern. It was christened the “New Normal” after the Great Recession in early 2009 to underscore that this recovery would instead be subject to an extended period of sub-par economic growth, higher unemployment, and a lower standard of living due to lasting effects of the financial crisis.

 

While this projection has held up over the years, the returns from stocks have actually been better than predicted by the New Normal hypothesis. That is primarily because corporations have been able to grow their earnings and profit margins, while earlier low valuations and historically low interest rates have supported multiple expansion, in spite of the sluggish economy.

It has been difficult to conceptualize how the current New Normal cycle will end. Late-stage cycles are typically characterized by economic growth slowing from peak levels, full employment and rising wages, aggressive Fed policy raising interest rates to contain inflationary pressures, and banks tightening credit conditions. All this culminates in a recession and a restarting of a new cycle.

All business cycles share patterns and sequences of how indicators progress over time. However, not all business cycles and their respective indicators play out the same way in every cycle. Since this conventional late cycle description does not seem to fully capture where we are today, it begs the question “what is different this time.”

Several factors have made the current cycle different: (1) the combination of excess capacity in the system resulting from the Great Recession and the ending of a long-term commodity super cycle, (2) an aging demographic, and (3) burdensome regulations on business. The combination of these factors has resulted in an economic recovery that has been slower than previous cycles, allowing this extended expansion to be insulated from typical inflationary pressures.

So, where are we in the cycle and what difference does this make to a firm whose emphasis is on security selection? There are clearly many different levers that drive stock prices and we believe most are company specific, but we also believe that knowing where a market is within a business cycle framework can provide valuable insight in structuring portfolio allocations to specific sectors and industries.

Today’s economy is at or close to full employment, wages are rising (see chart below), and the Fed is tightening monetary policy – all late cycle indicators. Other indicators like strong Consumer Confidence and tight credit spreads appear more mid-cycle. The distinction between one stage in a business cycle to another is not always clear cut. We do think the potential boost that could result from the new pro-growth, pro-business policy agenda could move the current cycle toward activities and characteristics more akin to those typically associated with the latter stages of the business cycle.

What matters most is whether the economy can grow faster without reviving inflation and thus keeping the Fed from a policy response that becomes too restrictive. This is what will determine how long this late stage cycle will last. The conundrum we posed earlier about how a New Normal cycle ends now becomes more a matter of when.

In future correspondence, we will share more specifics about how our study of business cycles can enhance the decisions that come from our primary focus on bottom-up, stock focused security selection.