Timing Economic Expansion
Selecting stocks is a tough process in the best of times, but when the length of the U.S. economic expansion is nearing a record, investors need to look at how a company will perform in good times and bad. Different industries and companies fare better across the stages of the economic cycle, where stocks with lower risk, fewer ties to discretionary income, and less hype will outperform when the economy sours. Forecasting is more of an art than a science, but there are indicators that can be helpful in determining these turning points.
Understanding when the economy might turn is necessary when analyzing companies’ growth plans. Will there be time if management requires five years of continued expansion to meet its goals or clean up its balance sheet? There are two indicators that can help answer this question.
The first flag is based on the outlook of economists. While market-based indicators are preferable, the Wall Street Journal’s Survey of Economists provides great context, and its trend can help confirm market winds. The chart below from February’s survey indicates recession fears over the next year are low. Recent tax reform has pushed out expectations of any recession as the WSJ noted in January: “More than 90% of economists said the tax cuts would increase GDP growth over the next two years, similar to their thinking in earlier months when the details of the legislation were still in flux.”
Source: February’s survey
Another warning flag is the start of a bear market, a 20%+ drop in prices. Supporting this legend, a CNBC study found: “On average, bear markets give investors about eight months of warning that a recession is on the way.” The indicator does not have a perfect record, but is still a good rule of thumb. Recognizing the start of a bear market is very tough but possible. An indicator that can help with identifying the turning point is margin debt.
Record margin debt is seen as a sign of high investor enthusiasm, often noted as a time of greed in the investor behavior cycle. Following greed is panic and bear markets. High margin debt, coupled with little investor cash on the sidelines, removes price support in downturns. As charted below, peaks in margin debt generally precede market tops. Despite the market correction in January and February, margin debt has yet to turn.