“No two business cycles are quite the same; yet they all have much in common. They are not identical twins, but they are recognizable as belonging to the same family.”
Paul A. Samuelson 1948
When it comes to equity investing, discipline pays. Emotions are a hazard. So, when the yield-curve “inverted” this summer it wasn’t surprising that many market commentators labeled the event a death knell and share prices tumbled. An inverted yield curve, which is generally regarded as a precursor to an economic recession, occurs whenever the interest rate paid on long-term credit instruments (like US Treasury bonds) is lower than that on short-term debt of the same credit quality.1 True, volatility is nerve wracking. But remember, for every seller; there’s a buyer. While some investors abandoned equities, others capitalized on weakness. And even though the jury’s still out, at this juncture the bulls hold the advantage. Measured year-to-date through September 30th, all of the broad market indexes posted impressive gains (S&P 18.7%, DJIA 15.4%, NASDAQ 20.6%).
How can long-term investors develop a feel for which way the economy is headed? Unfortunately, the odds that anyone can systematically anticipate the events destined to shape the business cycle are necessarily slim. But as we’ve discussed here previously, there’s an objective way to evaluate the likely outcome. One of the few economic theorems to survive the test of time is the idea that interest rates are forward-looking and linked to Gross Domestic Product (GDP). The challenge is to extract the informational content embedded in credit market movements and harness it to good advantage. Here’s where regression analysis and statistical inference come into play.
While the linkages aren’t perfect, our regression analysis, which uses decades of economic and market data, confirms that more than half of the year-to-year fluctuation in real GDP is explained by prior-year market fluctuations – an enviable track record (Figure 2). What’s the 2020 outlook? Our model indicates next year’s real GDP growth is expected to be positive albeit anemic (1.5%), as shown by the marker at the tail of the graph below.
Similarly, the consensus estimate for 2020 GDP growth remains in positive territory at 1.9% (Figure 3). A full-blown recession may well be averted despite considerable turbulence. 2
As with any statistical measurement, there’s a cone of uncertainty. Thankfully, rounding out the upcoming year’s outlook doesn’t require precision. A rough estimate will suffice. And knowledge of the model's error term allows us to estimate the probability of various scenarios panning out (Figure 4).
In sum, there are significant odds that next year’s GDP will be positive (86.7%). That said, there’s only a 13.6% chance it will prove robust.3 So, where does all this leave us? It is important to remember the economy and the stock market are not the same thing. While there is a strong relationship between the two, i.e. a weaker-than-expected unemployment number can drive stocks down or a sharp selloff in stocks can trigger soft economic data due to wealth effects, they are not required to move in lockstep. Given the economy’s immediate prospects, coupled with a healthy dose of headline risk, from trade wars to Brexit to impeachment hearings, caution is advised. Now’s the time to re-evaluate asset allocations and review the defensive nature of equity positions.
1 For a detailed discussion on inverted yield curves, see: Charles E. Babin & William J. Donovan, “Investing Secrets Of The Masters,” McGraw-Hill (1999), pp. 119-122, 126.
2 Remember, the popular definition of a recession requires two back-to-back calendar quarters of negative GDP growth, while the technical definition is a bit more complicated than that. The forecasts presented here are calendar-year estimates.
3 GDP outcomes greater than 3% are considered robust while those below this threshold are anemic.