In the five weeks since stocks broke sharply lower, the market conversation has been dominated by short-term, tactical matters: Will the recent index lows hold? Will they be “re-tested” soon? When might the 10-year Treasury yield hit 3 percent?
Yet shadowing these debates is a broader unknown: Just how late are we in the economic-expansion and bull-market cycle? This week will market nine years since the bear-market nadir of March 2009 and it’s almost as long since the last recession ended.
Coming into 2018, the general sense among professional investors and economists was that the cycle is mature, perhaps entering the latter stages, but not set to end imminently.
For stock investors, this meant believing there might be one final, exuberant upside flourish to ride until caution became the smart play. For economists, the question centered on whether the economy was already at “full employment,” a point at which further growth comes at a higher cost in inflation or unproductive activity and usually invites aggressive restraint by the Federal Reserve.
Figuring all this out has been complicated by the unusual addition of a deficit-financed tax cut for businesses and consumers at 4 percent unemployment and with capital already cheap and plentiful.
Here are some relevant indicators of where things sit and how much life might remain in the economy and markets:
Time-tested gauges of growth cycles say there’s plenty of runway ahead for the economy. Charles Schwab chief investment strategist Liz Ann Sonders notes the Index of Leading Economic Indicators has returned to record highs. After it climbs above the prior cycle’s peak, a recession has been, on average, years off. The LEI is now just 11 months in record territory for this cycle.
The long expansion and recent acceleration has finally closed the so-called output gap — the difference between real GDP and its theoretical potential level, which is roughly the limit for how much an economy can produce without triggering inflation. Once again,the economy tends to stay above potential for a while after it first starts running above that level.
Some big components of the economy do seem to have past their peak, of course. Auto sales reported last week suggested annual demand has seen its best days for now, with a bulge in activity following the 2017 hurricanes now past. Housing for now is still in growth mode, but higher mortgage rates and difficulties supplying new homes in a cost-effective and timely way are restraining this key sector.
This is typical late-cycle stuff — some areas soften up, bottlenecks emerge, the balance of power goes from companies to workers.
Bill McBride of the Calculated Risk economics blog, who foresaw the credit-crisis downturn and has been resolutely positive on the economy in recent years, is on alert now for treacherous opposing currents.
“With minimal policy changes in 2017, and a stronger global economy, the US economic expansion continued, pretty much as expected,” he wrote Friday. “But in 2018, the story is changing. We are seeing some economic tailwinds and some headwinds.”
“Although the tax changes are poorly conceived, and mostly benefit high income earners, there should be some short term boost to economic growth. That might lead the Federal Reserve to raise rates a little quicker than anticipated. And now the Trump administration is proposing tariffs and talking openly talking of a trade war. That is a downside risk to the economy. I still think the economy will be fine in 2018, but the story is changing,” he wrote.
Still, all the recession-prediction models “are still flashing green,” Ed Campbell, portfolio manager at QMA, said Friday on CNBC’s Worldwide Exchange. He sees another 12- to 18- months ahead in which the economy should remain supportive and stocks should be able to make more headway – especially over bonds.
Stocks rarely collapse more than 20 percent and stay down for a long time outside of a recession. Yet the way the stock market ran so far ahead of the real economy in the years since 2009 complicates the picture a bit. Equities became expensive and, in January of this year, over-owned and over-loved.
A higher-pressure economy with fewer resources to employ at high rates of return and high equity valuations are a formula for more market volatility.
Schwab’s Sonders says: “A trigger for this expected higher volatility — and more frequent pullbacks/corrections — could be tied to coming liquidity ‘squeezes’ courtesy of a more hawkish Fed this year, tighter monetary policy by global central banks, more stimulative fiscal policy, and even higher oil prices. Volatility spikes don’t tend to signal finales to expansions; but they do tend to signal late-cycle conditions.”
Global macro strategist Jurrien Timmer of Fidelity also is using a late-cycle playbook, in his case expecting the market’s price/earnings multiple to fall as rapid earnings growth outpaces market gains — which has already been happening this year.
The market clearly is struggling to determine the “right price” to pay for a bulge in profit growth from tax cuts that could mark the “good as it gets” moment for corporate bottom lines this cycle.
Another thing that happens late in a bull market but tends not to end it: When long monthly market win streaks are broken. Last month the Dow Industrials fell after 10 straight monthly gains. Typically the Dow has gone on to register further gains in the six months ahead rather than immediately give way to a bear phase.
Still, the clock ticks. Quantitative strategists at Bank of America Merrill Lynch track an array of 19 “bear market signposts” encompassing monetary, economic, earnings and technical indicators. Nearly all of them have usually been triggered before past bear markets. The most recent reading showed 68 percent of them (13 out of 19) were tripped.
Many disciplines and approaches point to a similar conclusion: It’s getting later, the market might stay bumpy, but it’s not quite about to end just yet.