Thoughts On Business Cycles, Recessions, and Financial Markets (Part 1)
Thoughts On Business Cycles, Recessions, and Financial Markets
As as student of economics, I am eminently fascinated with how such disastrous occurrences such as recessions cannot reliably be spotted in real-time. How can some of the smartest, most well compensated individuals in the world analyzing reams of data fail to spot economic weakness as it occurs? It is an amazing question.
Furthermore, how can I reconcile the fact that I believe short term returns are completely unpredictable (a random walk), while factoring in the work of Shiller et al that demonstrate that the overwhelming predictor of long term returns is starting valuation?
The implications are obviously profound, as late cycle, the current valuations suggest that the next recession is likely to be rather nasty with regards to equity prices.
Over the past several years I have thought about this, and have looked to the data, particularly the 2001 recession. I have come to have a bit of an epiphany relating to the nature of economics and financial markets in general which answers some of the longstanding questions that I have personally held for many years about the nature of the business cycle and how to position a portfolio, and as I find organizing these thoughts by writing them to be somewhat revealing in and of itself, thought I would share it on this blog.
To me, it’s a bit of a unifying theory that marries together a lot of my unsolved economic theories.
These thoughts may turn out to be completely incorrect, so I’ll mention the disclaimer that none of this is investment advice nor do I recommend any course of action for anyone else. You are free to take these thoughts as worth exactly what you paid for them: nothing.
I will break this into four separate posts with the following topics:
- Economic data during the 2001 recession
- On the nature of recessions
- My exit point: the yield curve
- My entry point: the NBER recession announcement
Economic data during the 2001 recession
Particularly for the 2001 recession, it appears to me that much of the weakness in the economic data occurred simultaneously with the drop in the stock market. The S&P sets a peak in October 2000, and by December’s low, it is already down about 15%. The trouble with most economic data sets is that they are not viewed contemporaneously: there is a delay to the data itself, the data is subject to revision after the fact, and downtrends are seen even in healthy ‘correction’ type events. I will try to summarize the key question:
If you needed to be able to sell the October top to avoid a 4Q 15% draw down, what could you look at that would differentiate something in the August or September of 2000 that was materially different than from what you might have observed in 1996 or in 2011? The latter 2 instances were situations in which the ‘typical’ measurements of economic strength would yield false alarms.
Frequently cited indicators are initial unemployment claims, the Conference Board Leading Index Indicators, and the Chicago Fed National Labor conditions. However, to me, each of this appears somewhat misleading. The CB LEI numbers themselves have more than a one month delay to them, so the latest observable value in October 2000 would have been the September 2000 number. This is how the data looked in the Fall of 2000 and in the Fall of 1995 respectively:
This is data as you would have seen it in December of 2000, by which point the market was already down 15%. Materially, the leading indicators are not materially worse than at other times.
Nor is the Chicago Fed National Labor conditions number, which reported the first parts of 1995 as weaker than the first parts of 2000 (on average).
And you would have seen a material increase in unemployment claims in 1995 as well.
Furthermore, an indicator based on the Chemical Activity Barometer shows some weakness, but nothing materially different than 2011, which was another year where the Chicago Fed said the labor market was worse than 2000. Again, by the time you are viewing this data, it is too late to miss the first 15% of damage to the portfolio. It was only with the benefit of an additional 3-4 months where it became evident this was no routine softspot but a full fledged recession:
It was only with the benefit of an additional 3-4 months where it became evident this was no routine softspot but a full fledged recession:
So, how does one differentiate between a 2000 and a 2011? How do you identify the false positives in the system? Can you? I have concluded, as I describe in the next post, that to a large extent you cannot.