The two recent plunges in the stock market have investors’ knees shaking. Is this a normal, healthy correction that forces expectations to align more with reality, or is this the beginning of the big one, the aftershocks of which will take the market down 50% as happened in 2000 and 2008? I’ll be able to tell you in about six months. I only predict the past because forecasting the future is too difficult.
A recent paper by the University of Chicago Booth School of Business professor George M. Constantinides and McGill University’s Anisha Ghosh, “What Information Drives Asset Prices?” offers some insights. One is that the Consumer Price Index and average hourly earnings provide better guidance about the direction of the market than does consumption spending alone. In other words, Keynes was wrong.
But the best insight is that the phase of the business cycle we are in offers the best advice on the market’s future. The authors call the phases “regimes” and uses just two, expansion or recession.
The consumption and dividend growth rates have higher means in the first regime than in the second one. Therefore we identify the first regime as the regime of economic expansion, with a higher mean of consumption and dividend growth rates and longer duration than the second regime...In other words, the investor is able to effectively forecast the regime in the next period...”
So the investors who accurately guess whether the next period will usher in a recession or continue the expansion will do better at predicting the market. The authors of the paper assume that investors use a range of macroeconomic variables, including Consumer Price Index and average hourly earnings, to guess what regime or phase of the cycle comes next.
Of course, Austrian economists already knew that. In the long run the market tracks profits and the business cycle determines profits. As Austrian economist Mark Skousen points out in his book, The Structure of Production, most people in finance and business have learned this from experience and follow a popular version of the Austrian business cycle model, although they don’t know its name.
However, mainstream economists and media are perpetually confused. Instead of thinking in terms of cycles, the media does linear forecasting: the economy is good today so it should continue to be good for the next year. Mainstream economists privately assume that recessions are random events and cannot be predicted. Market dives as happened recently they attribute to the “animal spirits” of investors. They will repeat the joke that the stock market has predicted ten of the last eight recessions, ignoring the fact that even if the joke were true the market would have a better record of predicting recessions than do mainstream economists who have been surprised by every recession since Keynes sent them on the wrong path. Publicly, they tell the media what it wants to hear: The economy is good today and so will continue to be good for the next year.
The truth is that most investors, the pros anyway, are trying to assess which phase of the business cycle will come next. We know that this expansion has lasted nine years and that’s far to the right of the average in a distribution of the length of expansions. Anyone who has employed the simple technique of using a Poisson distribution to predict rare events knows that.
We also know that near the end of an expansion the Fed tends to raise interest rates and bond prices are falling, which means higher interest rates. Many money managers use a simple formula to divide investments between stocks and bonds: they compare the yield of stocks with that of bonds and invest in the one with the higher yield. As interest rates rise, the yield on bonds becomes more attractive and that on stocks less so.
Another signal of the end of the expansion is a change in attitude toward good news. Until the end, good news for the economy means good news for stock prices. Close to the end, sentiment changes and good news for the economy spells trouble for the market because it increases the chances that the Fed will raise interest rates enough to choke off the recovery.
Recently, the Atlanta Fed forecasted 5% growth in real GDP this quarter. Growth for all of last year was around 2.6%. That’s a huge jump in GDP that rarely happens. If the economy is growing at that rate in this quarter, it means a leap in inflation and higher interest rates.
Mainstream media and economists will chide the market for its irrational behavior, but there is nothing irrational about it. Those of us who think in terms of cycles understand that surprisingly good news in the economy suggests the turning point, the end of the expansion, and not another year of good fortune.
So what should investors do? If I thought higher inflation and interest rates followed by a recession are coming then I would get out of the market and into cash for a while. It’s too late to buy protection with options. High volatility makes them much too expensive. I should have bought such protection last year when volatility was low.
No one can predict when the next recession will come. I have expected one for the past three years. Unfortunately, the stock market is the best predictor of recessions we have. The dives the market took recently may be a normal correction or they may be the beginnings of a bear market and recession.
The signs mentioned above point to a looming recession and that has political implications as well. The earlier in his administration a recession comes the better it will be for the prospects of President Trump’s re-election. The economy will recover from the recession and he can take credit for it. But if the recession is long or deep and the economy hasn’t recovered before the second quarter of 2020, the people will elect a Democrat president.