Recessions don't just "happen"

Posted 06 Jun 2014 by Rick Irwin, CFP, CLU

Markets have struggled so far in 2014, leading some to claim that the current recovery is about to hit a wall. The fact of the matter is that bull markets do not end because the markets had one especially good year or even a cluster of good years together. They end when the economy goes into recession; simple as that. In fact, seven of the last eight bull markets stopped due to recession.  The eighth was due to the 1987 market crash which was a unique event.

Recessions happen when the economy is overheating, leading to inflation. The central banks’ response to inflation is to raise interest rates. This leads to a slowdown in growth in the economy and the markets respond accordingly. Inflation currently is stubbornly low with the new Federal Chairman Janet Yellen claiming recently that she saw the risk of inflation below two percent as much higher than inflation being above two percent (a veiled way to suggest rates would not be rising any time soon, at least not in any way to shock the system.)

We know that central banks do intend to increase interest rates at some point from their current & unprecedented low levels but not due to an overheating economy; simply just to pull them modesty back up from near zero levels which were put into place to stave off the biggest credit crisis since the Great Depression. The current economic recovery is the slowest in the postwar period; partly due to the weak housing recovery and low levels of business spending, including things like new hires.

The media has been pounding the table, raising the alarm, that markets continue to “hit new all time highs” (which they always must do and have for hundreds of years)… keep in mind that these “all time highs” are just bringing us back to the level before the 2008 financial crash. (The TSX still has room to go to take out new ground.) New highs do not necessarily mean the markets are about to retrench.

Admittedly, markets have had a very good run since the lows of March 2009. Looking at the current value of stocks, as measured by the “P/E” ratio (stock prices relative to their earnings), multiples are only slightly above their long term average.  This current market dip is the eighth such one since the bull market began in 2009. Every time the fear mongering ensued, but markets pressed on further upwards, absent of any of the warning signals we see ahead of, or concurrent with, a recession.

Normally a precursor to inflation is a dwindling of spare capacity in the economy. Currently, unemployment rates are still stubbornly high and businesses are hoarding cash massively; both of which suggest that there is still idle capacity. Inflation is not present in the system and central banks have to be cautious when considering raising rates given the fledging housing and economic recovery and weak employment.

One of the most important indicators of a pending recession is an inversion of the yield curve, which is defined as a period of time when the yield (interest rate) on longer debt exceeds the rate of short term debt. I distinctly remember this happening prior to the large recession in 2000 and an inverted yield curve is one of the most reliable predictors of pending recession. In fact, the economy has never entered a recession without this occurring. Currently the yield curve is extremely steep.

There are several other things that tend to happen just prior to a recession; in most cases, all of which happen concurrently. One important barometer is a decline in business spending (as measured by the ISM, or Institute of Supply Management). ISM weakened in each of the last recessions, usually into the low 40’s, indicative of economic contraction, where it is in the mid 50’s today, well into where it is during periods of economic expansion. Other indicators that are absent currently include a recent spike in inflation, a significant drop in housing starts, a plunge in the average weekly hours worked and a tight labour market.

So while it’s safe to assume markets are going to enter a cooling-off period after the robust gains last year, there is little no evidence to suggest that a recession is pending any time soon and it is recessions that kill bull markets, not media talk of bubbles or mere fatigue after a few good years. Valuations of stocks are reasonable, though slightly high, but certainly nowhere near what could be considered bubble territory, inflation is not a problem and capacity in the economy remains high. There is always the risk of a geopolitical event-with the recent sabre rattling from Moscow being the last spook to the system-but if we accept that recessions lead to bear markets and indicators are that we are no where near recessionary territory, the odds are that we could be in a favourable market environment for several more years. Beware the bull.