Last Friday we talked about economic cycles and I mentioned that there are indications that the current expansion is not yet over. Let's go into a bit more detail.
Bull markets don't die of old age. You've probably heard that adage, but what does it mean? That saying implies that the absolute age, the number of consecutive quarters or years of expansion, has nothing to do with predicting or causing the end of the current expansion.
It's very tempting to look back at previous economic cycles, measure the average length, and extrapolate a similar end to the current cycle. In fact let's briefly walk down that path. In the post-World War II era, the average length of the growth phase of the business cycle (the period between recessions) has been 22 quarters. That's very close to the age of the current expansion.
To add a little perspective, the longest expansion began in 1991 and lasted 40 quarters. Behind that was the expansion that began in 1961, which lasted 35 quarters. However, the majority of other expansionary phases since 1950 have been shorter in duration than the current expansion, leading many to wonder if we are on the cusp of an impending downturn.
Instead of looking at the absolute age of an expansion, it's more appropriate for us to look at the relative age. Determining the relative age of an expansion relies more on assessing the macroeconomic fundamentals than counting the amount of time that has passed since the last recession.
Rather than old age, bull markets die when a recession is on the horizon — when we are about to switch from economic expansion to contraction. It is at that point that investors realize excesses have built up, and need to be worked off. Therefore, one of the best ways we can predict the end of a bull market is to predict the beginning of the next recession.
During my time here at DTL, I've shown and discussed a number of indicators that reliably predict recessions 6-12 months in advance, sometimes further. I'm not going to repeat those items here, as they will come up again in future remarks, but instead talk in a more general sense.
Many people have criticized this recovery for being anemic. They point to the sluggish pace of investment and hiring as a sign that not all is well. And to be honest, there may be a lot of truth to this. But there is a flip side to the sluggish pace of recovery, and that has to do with the pace at which excesses in the system rebuild.
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Many economists will tell you that the most frequent cause of recessions in the post WWII period has been excessive inventory accumulation. When this arises, we see a pullback in output, followed by layoffs, reduced spending, and an overall decline in production and productivity. The system must contract from the prior period of overexpansion and overproduction.
During this recovery companies have had a tendency to remain lean (not hire unless absolutely necessary) and refrain from overproduction. We can see this through various metrics, including labor statistics as well as inventory to sales ratios. This "lean" focus implies that companies are being especially watchful in terms of not letting excesses build, and this corresponds to a younger relative age in the business cycle than one might infer from looking at this expansion's absolute age.
We're seeing similar behavior by consumers, who remain reluctant to overextend themselves. The paltry pace of loan growth — part of the reason we are not seeing significant expansion of the money supply and thus building inflation — demonstrates that many consumers remain focused on repairing their financial situations rather than leveraging up. This type of behavior also acts to slow the pace at which excesses in the system build.
It's also important to look at the state of monetary policy, which in its current form will support prolonged expansion. The fact that short-term rates have not yet begun their ascent is another indication of a younger relative age to this market cycle. Low inflation and low wage growth provide the framework required for our dovishly oriented Fed to take their time normalizing interest rates, and this has the potential to delay the inevitable upcoming contraction.
Altogether, the state of various fundamental indicators as well as the general mood of apprehension among many consumers indicates that this economic expansion has more room to run. It's not guaranteed, but there are logical reasons why this current expansion may be longer than average in terms of duration.
The following was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
