INSIGHTS

On December 04, 2017

AAM Viewpoints – The 2nd Longest Expansion and One Reason It May Continue

It is more difficult to be an optimist than it is to be a skeptic. Over the past few years, optimists have weathered article after article predicting certain doom to the most unloved bull market in history. Simply typing “stock market” into Google will likely result in a top search suggestion of “stock market crash.” Our collective investing psyche shows how we and the media we consume are hardwired to be skeptical.

We are loath to believe a good story and in the words of Daniel Kahneman, “The brains of humans…contain a mechanism that is designed to give priority to bad news.” (Thinking Fast and Slow, Kahneman 2013). This bad-news prioritization clearly benefited our ancestors, skulking about as they did hunting on the plain wary of becoming dinner, but investing is different business.

The Business Cycle in Brief

Many analysts point to the current expansion being the second longest on record. Their fervent comments imply that length is the defining characteristic of an economic expansion. The rationale is that since this expansion has gone on a long time, it’s got to end sometime…doesn’t it?

Below is a graph of U.S. Real GDP from 1948 to present, from which we can draw a handful of simple observations:

• Since WWII, the United States has experienced 12 expansions and 11 recessions.

• The average expansion during this timeframe is 60 months.
  
  
  
  • The longest expansion from 1991 – 2001 was 120 months
  
  
  • The shortest being a "blip" between the double-dip recessions of 1980 – 1982
  
  
  
  

• Post WWII, the average recession has been 11 months long.
  
  
  
  • The shortest recession was the first eight-month slowdown of the double-dip recessions in 1980
  
  
  • The longest being 2007 – 2009 at 18 months. A mere two months longer than the recessions of 1973 and 1981
  
  
  
  

• Duration of an expansion is merely one aspect and gives no insight into its ending.

The Yield Curve Remains Our Most Reliable Indicator

We recently witnessed the two strongest consecutive quarterly GDP results since 2014. Since the end of the most recent recession, only seven of the past 33 quarters have experienced higher GDP than this past quarter. We have also witnessed 18% gains in the S&P 500, 22% gains in the Dow Jones Industrials and the 7% from the Bloomberg Barclays U.S. Corporate High Yield Bond Index in this year alone. All of this in the face of an expansion that some say is “long in the tooth” and amid calls for recessions in 2014…2015…2016….

We have often referenced the Treasury Yield Curve as one of the best predictors of future economic activity 12 to 18 months out. The long end of the U.S. Treasury Yield Curve tends to be influenced by market forces from long-dated Treasury buyers such as pension funds, insurance companies and sovereign agents. The short end of the yield curve is influenced by the actions of the Federal Reserve and open market operations aimed at managing the Federal Funds Rate.

The interplay of these two forces in shaping the yield curve results in comments such as these from Arturo Estrella and Mary R. Trubin in their 2006 Federal Reserve study “The Yield Curve as Leading Indicator” (2006) supporting the yield curves veracity as a leading indicator.

“Consider, for example, that all six (NBER) recessions since 1968 have been preceded by at least three negative monthly average observations in the twelve months before the start of the recession…. Moreover, when inversion on a monthly average basis is used as an indicator, there have been no false signals over this period.”

While the current yield curve may be flatter at present than at any time during this expansion, it still remains positively sloped. It is important to note that over the course of the past 40 years, there have been periods where flattening curves were not the harbinger of doom some prognosticators preached. Most recently, in December 1994 the difference between the 10- and 2-year Treasury fell to 8 bps (basis points) yet the economy had another six years of robust growth ahead of it. Today, this spread is 58 bps.

While the spread is flatter than any time recently, we feel this continues to be a clear indication of economic growth for the coming 12-18 months.

CRN: 2017-1204-6285R