In general, most people understand that the economy tends to be cyclical with times of growth, followed by times of contraction. Economists describe this rise and fall as the “business cycle”. A typical business cycle will include an expansionary time (things are starting to get better), followed by a peak (things are as good as they will get), followed by contraction (things are getting worse), followed by a trough (things are as bad as they will get). Business cycles occur due to two main reasons: 1) an overabundance of confidence or risk taking (the Peak) and 2) an irrational fear of doomsday scenarios (the Trough). Unfortunately, we as Americans continue to do this to ourselves over and over again.
The business cycle is somewhat managed (and created) by fiscal and monetary policy. As the business cycle extends through the expansionary phase, Congress and the Federal Reserve may take actions to slow down consumer spending and risk taking. This may include actions such as increasing interest rates, cutting federal discretionary spending, raising taxes, ending federal subsidies, etc. Alternatively, during the contraction phase, actions may be taken to stimulate the economy. Recently we have seen these actions through Bush/Obama era tax cuts, extension of unemployment benefits just after the financial crisis, the Federal Reserve lowering interest rates and purchasing Treasury securities, multiple tax credits and subsidies, etc.
Business cycles are cyclical by definition and we are continually moving through the different phases. Below is an image1 to help illustrate how the cycles work.
Where we are in the economic cycle has a direct impact on the stock market. As the economy does well, we would generally expect companies to also do well. As the economy slows, we would generally expect companies to be more challenged. So clearly the business cycle is very impactful to the stock market as a whole.
Since the price someone is willing to pay for a stock is generally ascertained by the future cash flows and value of the stock, many believe that the stock market can be a leading indicator of the business cycle. Because of this, markets are not always reflective of the current economy but may rather be a predictor of future economic conditions, both long and short. While this is certainly not a guarantee and not always the case, Jeremy Siegel’s (a Wharton business professor and well-respected economist) research indicates that 43 of the past 47 US recessions have been preceded or accompanied by a 10% decline in the stock market.
So, this begs the question… “Where are we in the market cycle?” The honest answer is nobody knows, and nobody will know until we are looking in the rear-view mirror. Hindsight is 20/20, right? We do believe few would argue that we are not already out of the trough and have experienced many years of expansion. The larger question is: “Are we still in an expansionary environment, or are we peaking, or have we possibly already peaked?” We will not be able to answer this question with complete accuracy for some time to come. However, nearly all pundits, economists, and analysts alike are predicting a less booming economy over the next several years.
So, if the market is a leading indicator and we are likely on the longer end of the positive market cycle, should we become more conservative? We believe the answer is a fundamental yes and a fundamental no. We always believe that the market can take a correction at any given point and with that said, we always encourage clients to have cash/secure money on the sidelines if they need it in the near future. Generally, we would encourage safer money for at least 1-2 years if retired and a healthy emergency fund if working.
The “no” answer to the above question is in relation to long-term goals. The fact of the matter is that markets will reverse course many times over one’s lifetime; markets go up and markets go down. Based on present knowledge we do not foresee anything unusual about the current market conditions. While we certainly do not take a laissez-faire approach to investing, we do recognize that our investments should be managed for the long-term, which will see many ups and downs over time. Overreacting to market conditions can lead to market timing, which we all know is a potentially dangerous game.
As we enter a period of potentially increased volatility, we believe it is important to review and recognize the emotions investors face. Below is a chart of investor emotions and the points of maximum financial risk/opportunity. These feelings are similarly tied to the business cycle and stock market cycle – all cyclical in nature.
In conclusion, we recognize that the expansion phase of the market cycle is extended, and we may be nearing or even past a peak in the market cycle. This does not mean run for the hills and this does not mean that the market cannot continue to go up over the near term. During phases like these (as always), we do strongly encourage clients to review their risk tolerance, make wise decisions for near term money needs, and continue to stay the course. Uncertainly and market volatility should not cause one to change their long-term financial strategy.
2: Yahoo! Finance