Business Cycle Buyers Beware
Stock prices not yet spinning at the speed of 'recession'
By Brady Willett

It is ironic that many investors who did not believe the business cycle existed two years ago now live and die by supposed BC developments.  To be sure, the best jungle to surmise the stock market rally since September 22 is 'Buy now for the coming economic rebound'.

The above chart represents United States business cycles from peak to trough.  Fourth quarter 1999 GDP is the latest GDP peak , and March 2000 (dependent upon which business cycle methodology you apply) is the latest business cycle peak.  As such, the current economic contraction has been ongoing for roughly 19 months.

Since 1950 the longest economic contraction from peak to trough has lasted 16 months (November 1973 – March 1975, and July 1981 – November 1982).  Furthermore, since 1950 the stock markets, without exception, have formed a bottom before the reversal of economic misfortune arrived.  As such, if the last business cycle peak was witnessed in early 2000 then the current economic contraction will rank as the longest since 1950: this following what was the longest economic expansion ever. 

With these things in mind (that we are amidst the longest economic contraction since the great depression) it is not surprising that many economists, and analysts are calling for an economic turnaround in the not too distant future.  As well, such an analysis also argues that with the coming economic expansion the stock markets will ultimately rally. After all, the average expansion since 1950 has lasted roughly 50 months: meaning that if such an expansion were to begin in Jan 2002 the peak would not transpire until sometime in the year 2006. 

However, investors have been hearing, and acting (buying) on similar renditions of this mantra for much of 2001, or that the business cycle contraction will soon close in on 'record' territory and then an expansion will unfold. To be sure, recently worrisome economic statistics, and corporate earnings have not detracted from continuing to form this basis of optimism. Rather, the tepid theory to be made following the markets march past September 10th levels is that if the economic situation is worsening investors must 'buy now' before its condition improves…

The potential problem with this dogma being readily ingested by investors is that it detracts further from equity/economic fundamentals.  By comparison, most people agree that the main problem with the 1990s tech bubble was not that technology achievements were not dramatically changing the economy, but that the companies promoting such a change owned stock prices that were 'too high' based upon potential earnings.  As such, with investors focusing on the 'upcoming' economic rebound today rather than corporate fundamentals, one could argue that a similar bubble (or expansion of the previous) is holding stocks above their realistic potential.  Nevertheless, why not buy if the economic contraction must soon end, and stock prices always bottom before the economy?


Herein rests the fault of narrowly cited historical extrapolations: if one goes back far enough there are always other historical contexts which combat myopic conclusions.  For instance, the U.S. economy reached a concurrent peak with stock prices back in August of 1929, and the economic contraction did not subside until March 1933, or 43 months later.  43 months?  By current standards this would mean no trough (or bottom) until the fourth quarter of 2003.  Another example that challenges the 1950 'facts' is the October 1873 economic peak that did not unwind until March 1879, or 65 months later.  65 months would equate to an economic bottom not arriving until mid-2005. For those investors buying today expecting a turnaround next year, one can only assume that damage in the stock markets would be stifling if the economic trough does not arrive for another 2-4 years. 

Lastly, while many equity holders may be confident that the economy will soon bottom out, they are not buying into an 'undervalued' market in any traditional sense of the word. Furthermore, with corporate earnings being predictably anemic until at least mid-2002 one has to wonder how far this market can run without smashing into the valuation wall.  Are those investors who previously believed the laws of the business cycle had been repealed now completely ignoring 'high valuations' and using the business cycle as their defense? 
 

In sum, nearly everyone is in agreement that stocks are rallying for no tangible reason other than optimistic expectations of the future.  Moreover, there can be little doubt that these cheerful expectations have been facilitated, in large part, by a myopic translation of business cycle history. As such, the biggest threat to economic recovery may not be botched government stimulus packages, and/or the continuous colandering of the U.S. labor market. Rather, that equity prices begin to reflect the tangible tapestries of the dilapidated domestic economy.

November 5, 2001



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