The Business Cycle Is Not Over Yet

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Jul 7, 2017 3:05:15 PM

and tagged Commentary

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the business cycle is not over yetThe news this morning on the jobs report was much better than expected, with a strong June offsetting a weak May. This supports the idea that some of the weak data we’ve seen recently is just a summer slowdown, rather than something worse. And with consumer and business confidence still at high levels, prospects for the immediate future continue to look good. This, in fact, is why the Fed and other central banks are in the process of tightening monetary policy.

This might seem to call into question my own take that we are headed for a recession sometime in the next 12–18 months, and that said recession could possibly lead to a replay of 2000–2001 in the financial markets. After all, if things are good, can’t we expect them to stay good and maybe even keep getting better? That seems to be what the stock market, among other indicators, is saying.

The seeds of future trouble

Maybe so. Expecting good conditions to keep going indefinitely, however, has always been a bad bet. In fact, it is usually when conditions look good—and have looked good for a long time—that the seeds of future trouble are being sown. The better people feel, the lower their perception of future risk, and the greater chances they take, especially by borrowing more.

We can see that in the current financial markets. One of the arguments against my 1999 comparison is that we don’t see the euphoria now that we did then. Certainly, I get it: no one has actually argued for the New Economy yet, at least to me. But, at the same time, I do hear quite a bit about the “sharing economy” and its poster children, Uber and Airbnb. The sharing economy is definitely one element that could make the outcome different this time, and it’s being used to justify the massive valuations of headline companies. I also see massive valuations of tech companies that are changing the course of business; Amazon, in particular, is in its second version of this role. The differences between now and then are certainly there, but so are many similarities.

On a more quantitative level, when we compare the relevant economic stats, we see that the most comparable time over the past couple of decades to right now is, in fact, 1999. To wit:

  • Consumer confidence is the highest it has been since 2000.
  • Business confidence, measured by the Institute of Supply Management surveys, is actually higher now than it was then.
  • Stock valuations are higher than they have been at any time since 1999—and 1929.
  • Investor confidence, as expressed in the VIX, is considerably lower than it was in 1999. The VIX is actually at its lowest level ever. That confidence is leading investors to take more chances.
  • Margin debt, as a proportion of the value of stocks as a whole, is at the highest level ever.

My take on Uber and Airbnb is arguable. The numbers are not. When I look for signs of euphoria, the fact that investor fear, per the VIX, is at an all-time low, while investor exposure, in the form of borrowed money in the stock market, is at an all-time high is all the proof I need. Euphoria is here.

Why it’s not different this time

What would make that euphoria correct? Only if we, in fact, see continued expansion and business improvement. Only if the business cycle is over and we are in a new era where the economy just keeps going. Only if, in fact, things really are different this time.

Unfortunately, we can already see the cycle turning. Today’s strong monthly jobs report doesn’t change the fact that job growth has slowed over the past two years and is slowing even more on a longer-term basis. High consumer confidence levels don’t change the fact that spending growth has slowed. The Fed’s confidence in the economy is leading it to raise rates, which is usually one of the key events leading to the end of the cycle. All of the economic statistics are telling us very clearly that it is not different this time, even if conditions are good right now. We are late in the cycle and getting closer to the end every month.

But the business cycle is not over yet, nor is the stock market cycle. Keep that in mind as you plan for your investment goals over the next couple of years. The surest proof that it is not different this time is how many people are saying that it is.

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