published: October, 31st 2016
By Rick Wedell, CIO
Weekly Update 10/24/16 – Recession Timing
Time for the weekly market update! We skipped last week because there wasn’t all that much to talk about. I thought about skipping this week too, because, well, here’s a chart of the S&P500 price action since July:
If it were a patient in a hospital it would have died of boredom, and the past two weeks have not been any different other than a brief “China slowing wait not they aren’t” dip and rebound last week. The VIX* is at 13.30 which is REALLY close to the level at which we will add to the Focus Plus and Focus Plus Enhanced models in small size. This continues to be driven by what we have talked about before – the 2200 effective ceiling on the S&P 500, combined with little in the way of material downside risks to the economy, leaves an apathetic market that doesn’t really feel the need to bleed lower, but doesn’t have the upside potential to grind higher. So, what do we talk about when there isn’t much to talk about? Well, the investment team took a vote, so here we go:
There has been a lot made of the fact that we are long in the tooth on this cycle – the economic expansion has lasted 87 months, which makes it the fourth longest in the post WWII period. It will soon become the third largest, assuming it lasts until January, and I see little reason to believe that it will not. A simplistic reading of that situation could lead you to believe that a recession must be just around the corner and that you should radically alter your portfolio positioning to account for this. I’m going to try to show you why that’s not really a wise move in the next couple of paragraphs.
The first reason why we shouldn’t be OVERLY concerned about the age of the cycle is that the distribution of economic cycle ages is 1) not uniform and 2) not constant over time. Said differently, if you look at the data, there’s not a whole lot of evidence that there is a good “average” recession length to use, and that the further you get from that average the more likely you are to see a recession the next month. Perhaps more importantly, though, there is strong evidence to suggest that business cycles last longer now than they did in the past. Per Bloomberg, the average length of a cycle during the time period from WWII to 1980 was approximately 4 years. The average length post 1980 has been closer to 6.5 years. There are two dominant theories behind why the business cycle is elongating. The first is that we are MUCH better at managing monetary and fiscal policy than we used to be – remember that the link between inflation and unemployment, which is the very foundation of our current monetary policy regime, was only formally articulated in 1958 and it took time to be widely accepted and then used as a basis for economic policy. The second is that our transition from a primarily industrial economy to a service economy has helped to dampen the volatility within the cycle, as manufacturing is more prone to wild swings in economic output (more on this when we talk about horses later). You put both of these together and we get longer economic expansionary periods, so a simple “it’s lasted longer than a lot of the cycles in the 40’s and 50’s” is not an overly helpful statistic.
The second reason we should not be overly concerned about the age of the cycle is that economic cycles generally end in response to some form of economic shock, which is normally due to some sector of the economy overheating and then cooling off. In 2001 it was tech, helped by 9/11. In 2008 it was housing, which then spilled over into the banking system. The oil shock in 2015 was theoretically enough to push a normal late cycle economy into recession territory, and it actually somewhat speaks to the strength of the current cycle that we were able to come through it and still post economic growth. I personally cannot point to exactly what the sector shock will end the current expansion, but it will likely come about as some sector of the economy overheats and then contracts, which will then flow through to other sectors. Given that we are just beginning to see real wage expansion / labor tightness in the past few months, it seems reasonable to believe that we have some additional runway before we move into “overheated” territory.
The last reason we shouldn’t be overly concerned about the length of the cycle is actually the most important, however, in my humble opinion. Whatever your bent is towards investing in the markets, it’s generally smart to stick with it. You can be risk on or risk off, and for the record I would probably argue for more of a risk neutral to risk off positioning at this point, but you should couch that in terms of whatever your dominant investment strategy is. Said differently, choosing to hedge a little here to guard against your downside is probably prudent (hence the VIX). Choosing to move predominantly to cash is not. If you are a bull, be slightly less bullish. If you are a bear, be slightly more bearish. We’ve all seen the 10 worst / 10 best days analysis done in the past, and the evidence would suggest that over time, people who move wildly from bull to bear and back again are highly unlikely to outperform. Stick to your guns.
That covers that – no trades in the portfolio in the past few weeks as there hasn’t been any real catalysts to trade on. If the VIX breaks 13 we will add as a hedge in small size against the portfolio.
On to this week’s story time: When I was younger, I spent a month at a camp up in Mentone every summer. I enjoyed the outdoors, and my parents enjoyed having my sister and I out of the house. To be clear, I was not then nor am now a particularly athletic person, and so my activity selection at camp would tend to skew towards activities like archery or canoeing versus, oh, let’s say basketball/soccer/football/tennis/lacrosse. One of my favorite activities was horseback riding. This is not to say that, in certain circumstances, horseback riding is not a physically demanding activity because I’m sure it is. It is to say, however, that “camp” horseback riding is a pretty leisurely affair of trail riding on horses that have ridden the same paths for generations and thus know exactly where and how fast they are going on any particular day or ride – sort of like a mid-1980’s equestrian version of Uber – which 12ish year old me thought was amazing. Anyway, the one lesson that I took away from those 10 summers of trail riding, because it would be screamed at you by the instructors incessantly, was that if you had to walk around the rear end of a horse, you should stand as close to it as possible, the reason being that if a horse decides to kick you, it’s better to be close than far away.
To see why, do the following:
Ironically, an industrial economy is not unlike being kicked by a horse, in that if the end consumer decides to decrease their demand, it is better to be as close to that consumer as possible, supply chain wise. This is what we call the “bullwhip effect”, which is so named because when you snap a whip, the tip moves much faster than the hand which holds the whip. To see this in the economy, think about three producers: Bobby produces cars, Shannon produces steel, and Counce produces iron ore. In steady state, Bobby sells 100 cars a year, Shannon sells him 100 tons of steel to do it, and Counce sells 100 tons of iron ore to make the steel. They each have roughly 50% of sales in inventory at any given point, or 50 units, to keep the business going. So long as sales are constant at 100 per year, everyone is fine.
So what happens if demand drops by 20 units (which is roughly the demand drop we saw in discretionary retail in the last recession)? Well, Bobby is only going to sell 80 cars, BUT more importantly for our purposes, he only needs 40 units of inventory (50% of 80). So he turns and drops his normal 100 unit order to 70, because he needs 20 fewer for the 20 he’s not going to sell and 10 fewer for the drop in his inventory. Shannon, in turn, only needs to sell 70 units this year, which means she only needs 35 units in inventory, so she will turn to Counce and order only 55 units of iron ore. Her order (and Counce’s revenue) drops by 30 due to the fewer sales, and by 15 due to the inventory reduction. For those of you keeping score at home, Bobby saw a 20% revenue reduction, Shannon saw 30%, and Counce saw a full 45%, largely due to the impact of inventory movements. If Counce has a supplier, you can bet that supplier will have an even greater revenue hit, which is why I say that if the consumer is going to kick you, you had better be close to the horse. This is why auto retailers and manufacturers are less volatile than their suppliers, and why chemical companies or natural resource companies tend to be the most volatile of all given their position at the tail end of the supply chain. In a service economy, since you have minimal inventory, you get minimal amplification of demand destruction, and so folks further down the chain get whipped around less.
*The Chicago Board Options Exchange Volatility Index (VIX) is used by stock and options traders to gauge the market’s anxiety level and shows the market’s expectation of 30-day volatility.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss. Investing involves risk including loss of principal. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies. The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries