- While market volatility has increased, investors should be careful to distinguish risks from myths.
- A historical perspective can be helpful for interpreting economic indicators.
- There can be a long lag between the peak of an economic cycle and a recession.
Myth 1: The economic cycle has reached its later stages, and the expansion is near an end.
Reality: Expansions do not come with an expiration date. In addition, the United States has never had as much economic stimulus so late in a cycle as we have today. Stimulus measures include lower corporate and individual taxes, deregulation, and higher government spending. Although our current recovery is almost double the length of the average expansion since World War II, the reality is that there is no reliable way of predicting the end of a cycle based on its length.
Myth 2: PMIs — Purchasing Managers' indices — have already peaked this cycle, and can only decline from these levels.
Reality: The PMI is an important indicator of the future demand anticipated by businesses, but while recent readings have subsided, nobody really knows whether we have passed the peak of the cycle. Last year we saw a reacceleration, and this could happen again. There have been times in the past, including the mid-90s and mid-00s, when PMIs hovered just below 60 for extended periods. In other words, stable mid-cycle strength is not unprecedented. Ultimately, the peak in PMIs is only clear when it is distant in the rearview mirror. What is even more important for investors to realize is that economic recessions historically have not started until years after the peak in PMIs.
Myth 3: We have already passed this cycle’s peak in earnings growth. Earnings can only get worse.
Reality: As with PMI cycles, we will not know when we have reached peak earnings growth until the peak is distant in the rearview mirror. Investors should also be aware that, as with PMI cycles, there is no direct historical correlation between earnings growth peaks and economic recessions. The lag between an earnings growth peak and a recession is typically a matter of several years. And so, if bears today are right and the peak in earnings growth is in 2018, history would suggest that the next economic recession is years away. Furthermore, even when earnings growth does peak, the absolute level of corporate profits has oftentimes continued to increase. This is the case today, given earnings expectations for 2019. For this reason, the equity markets have historically experienced positive returns from the peak to the next economic recession.
Key point: The risks associated with the length of the current economic expansion and the timing of the peaks in PMIs and earnings growth should not be ignored. However, even if the bears are correct in interpreting the data, history suggests that the next U.S. economic recession — and corresponding bear market — is years away.