For many investors, the business cycle is a tool used to help build an allocation that will outperform during certain phases of the cycle. By analyzing an economy’s phase in the business cycle the investor hopes to anticipate changes and take positions in sectors that will outperform the rest of the market. However, it is not always as easy as it sounds to pinpoint where you are in the business cycle.
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What is the business cycle?
The business (or economic) cycle is made up of four phases: expansion, peak, recession, and trough. Expansion is an economy’s natural state, and is characterized by rising GDP, low unemployment, healthy sales, and steady wage growth. An economy enters the peak phase as growth slows and inflation continues to rise. When inflation rises faster than the economy is growing, it will begin to head into a recession. During a recession, economic activity slows, wages drop, and unemployment rises. Eventually, the economy will begin to stabilize and enter the trough period before beginning the next expansion.
In a healthy economy, expansions are the norm with recessions being short and infrequent. The National Bureau of Economic Research (NBER) is responsible for marking the official dates of the business cycle in the US. According to NBER, the Great Recession (2007-2009) was our last recession, and we have been in the expansion phase since 2009.
Where are we in the expansion?
Using the current economic data, it is easy to identify that we are in the expansion phase of the business cycle. The current debate is not which phase we are in but where we are in the expansion. To find the answer we must first look at historical business cycles. The length of expansion periods has constantly increased since the 1990s and some economists even wondered if this would lead to the end of the business cycle as we knew it. In 2007, hopes of a (mostly) continuous expansion were crushed as the US fell into the deepest recession since the Great Depression. This recession became known as the Great Recession, and it proved the business cycle was alive and well, but this doesn’t mean expansions are not changing. Expansions are getting longer, and our current expansion will be the 3rd longest in US history by March. In addition to being a long expansion, our current expansion is much slower than usual. Since 2009, we have seen an average GDP growth of only 2.1% while previous expansions saw growth closer to 3%. Slow growth has made this economy very stable and kept inflation at bay, but it has also left investors feeling less than thrilled about their returns.
A long, slow expansion has not only been hard on investors, it has also made it difficult to pin point exactly where the US is in the current expansion. The main question is whether we are in the mid or late expansion phase. In other words, are we going to see continued growth or are we heading into the next recession? To answer this question, we must look at four key economic indicators: employment, personal income, industrial production, and sales.
Full employment is seen as an indicator that an economy is entering the late phase of an expansion. When an economy is at full employment, businesses can struggle to grow due to the inability to find skilled labor. According to the Bureau of Labor Statistics, current unemployment numbers have been below 5% for the past 6 months. This is well below the 50-year average of 6.2%, and is also below the generally accepted full employment rate of just over 5%. However, full employment by itself does not always mean an expansion is ending. Healthy economies can last years at or near full employment as long as inflation is under control.
As unemployment falls wages generally rise as companies compete for candidates. However, in our current expansion wages have not increased in the same way as previous expansions. Wages have only increased 2.4% through November 2016 compared to the 50-year average of 4.2% annually. Again, we see this trend of slow growth during our current expansion. But, wages might not be growing as slow as the numbers show. The US is also going through a large demographic change. As the Baby Boomer generation ages and retire, they are replaced in the workforce by younger workers. These younger workers are not able to command the high salaries of the Baby Boomers. Naturally, the aging population of the US works to counter act wage growth meaning that our economy is most likely seeing healthy wage growth that will help continue this expansion.
During an expansion, industrial production increases. This is due to increased consumer buying power and an associated increase in their demand for goods. Current industrial production has been modest. Three key sectors of industrial production are manufacturing, mining, and utilities. The Federal Reserve monitors these sectors (among others) to calculate the growth in production. Since 2012 industrial production is up 4.6% and was up 0.5% in 2016. Although slow, the growth is strong and sustainable.
Sales indicate whether or not consumer demand is on pace with production. The US Census Bureau releases sales data on or around the 13th of each month. One measure of sales is the inventory sales ratio, this ratio measures how fast companies can sell their products. Higher inventory sales ratios indicate more sales. For much of 2016 we saw inventory sales ratios falling. However, there was a slight uptick towards the end of the year. A falling inventory sales ratio suggests that sales are slowing. But there are pockets of rising sales in housing and light vehicle sales. In addition, manufacturing and trade inventories are decreasing. This mixed result is consistent with the slow steady pace of this expansion and December’s numbers will be important in determining how well sales did in 2016.
Analyzing these market segments shows the difficulty economists have when determining where the US is in this expansion. In addition, the slow growth and increased length of this expansion add more layers of difficulty. When an investor is faced with the decision to build a portfolio based solely on speculation it begs the question, is it worth trying to time the business cycle?
Determining where an economy is in the business cycle is difficult and timing the business cycle is even harder. Because our economy has been growing slowly through the entire expansion, many investors don’t feel like the economy is in as good of shape as it is. It is tempting to try and time the market to seek higher returns. The long slow growth has made it hard to forecast market trends, but it isn’t all bad. Slow growth is keeping the economy from overheating and it is very likely to see continued growth. However, this does not mean we should make the same mistake and believe recessions are over. The business cycle is alive and well and we expect to see more periods of recession and expansion. It is important to keep a diversified allocation designed to last the test of time and perform in all market conditions. In our portfolios, we take a balanced approach using securities from across all sectors and market capitalization.