What if we are not 'late cycle' but actually 'early cycle?'
On today’s 90th anniversary of “Black Tuesday,’’ the market crash of Oct. 29, 1929, that ushered in the Great Depression, I’m reminded that almost everywhere I go these days, I hear market pundits and the bears warning that it’s “late cycle.” That is, this economy and market have had a good run—a record-breaking one in terms of the length of this expansion. But alas, as we learned so painfully 90 years ago, nothing lasts forever. So these bears recommend that investors be cautious and adjust their portfolios accordingly, as the inevitable downturn could be just around the corner because, you know, “it’s late cycle.’’
Readers of these pages know that we’ve spent a good deal of time at Federated thinking about the economic “cycle.” Very few of the folks we speak with on Wall Street can give us a cogent explanation of what a cycle actually is and what the statistical meaning is of an “average” cycle when we’ve only had 13 recessions since 1929. My conclusion is that the very term “cycle” is a misnomer in today’s services-driven economy. On the manufacturing side, to be sure, we have classic cycles. Supply gets a little ahead of demand, and then to get inventories in line, manufacturers are forced to scale back production dramatically—a down cycle. Once inventories are balanced, they restart production and a new upcycle begins. Importantly, manufacturing cycles have a way of curing themselves once inventories have been adjusted and manufacturers have to reboot production to meet demand.
By comparison, in the services side of the economy, consumer-driven demand tends to be steadier and, importantly, there are no inventories to balance. And the costs of downshifting—i.e., firing skilled services sector employees—can be quite high given how expensive it is to recruit, rehire and retrain new workers later. So absent a financial crisis that forces services sector layoffs, the services-based economy rarely produces negative quarter-over-quarter growth for two quarters in a row, the classic definition of a recessionary “down cycle.”
When you add all this up, you begin to see that the economy at a gross level is a more gradual-moving machine than a volatile one. Sure, slowdowns and soft patches appear along the way due to the drag of the “manufacturing cycle.” But for those waiting for the kind of economic pullback that would happen if the economy were purely a manufacturing driven one, well—they might be waiting for Godot. Yes, there was a time that when manufacturing caught a cold, the economy got the flu. In the 35 years prior to 1985, when manufacturing was the largest industry in the U.S. as measured by contribution to GDP, its cycle resulted in seven recessions, with an average expansion lasting almost 4 years. In the 35 years since, the average expansion has lasted an average of 8.5 years, with only three recessions interspersed. Put simply, in this “post-industrial” age, expansions tend to be longer and recessions more rare.
Our conclusion is that while everyone else seems to be thinking we are “late cycle” with the really big economic decline in front of us, we are in fact “early cycle” with the global manufacturing recession now bottoming even as the services sector continues to chug along. Indeed, the manufacturing side of the global economy began its downturn a full 11 months ago, and seems now to be near an interim bottom. Meanwhile, the Fed and European Central Bank are pumping in liquidity to avert a down cycle that is already behind them, which should strengthen the up move and certainly put a bid under financial assets. Right on cue, the confidence-sapping China trade war and Brexit battle appear both to be fading. Bond yields are bottoming and the yield curve re-steepening. Earnings downgrades also are bottoming and are showing signs of life. Does any of this smell like late cycle? Doubtful. If anything, we are in the early stages of a recovery. And where will this market head once consensus begins to sniff this out?
So go ahead and worry if you must. That’s just fine for the market. It helps prevents the sorts of excesses that can overprice stocks and undermine the economy. Indeed, relatively high levels of bearishness as suggested by the latest investor sentiment readings tend to be “early cycle’’ indicators. To wit: when the market crashed so many years ago, it came against a backdrop of excessive investor optimism, the exact opposite of the case now. As we close out the year and move into 2020, it’s possible this market may move through Federated’s longstanding 3,100 year-end target on the S&P 500 a few weeks early. In fact, our guess is that at this point, the market risk is skewed to the upside. Our target for 2020 is 3,500, so there’s plenty of room to go. Because it’s early cycle, not late.