Don't See the Sunny Sky for the Clouds

04/18/2011 3:45 pm EST

Focus: MARKETS

James Stack

President, Stack Financial Management

Though the economy and the market are headed for a rockier ride down the road, this is no time to hop off, writes James Stack of InvesTech Research.

First, it was considered a bull market that couldn’t possibly be. Then it was a bull market that couldn’t possibly last.

By last summer, with the Dow Jones Industrial Average dropping more than 10%, it was a bull market that was already over. And today, it’s a bull market that still can’t get any respect.

Almost every correction has been greeted with anxiety on Wall Street and belief that the final top was in place.

And from a historical perspective, this bull market has had plenty of corrections. In the first 25 months, the current bull market has experienced seven separate corrections of 5% or more (the latest coming on news of the Japanese earthquake and tsunami). That is the greatest number of 5% corrections in the first 25 months of any bull market of the past 70 years.

The simple fact is that corrections are an important part of every healthy bull market. They keep expectations in check, and speculation at bay. It’s when you experience the long, correction-less periods that major surprises can hit.

It’s not hard to reason that the US economy is headed for slower economic growth in the decade ahead—especially when compared with the 1980s or 1990s:

  • Consumers are carrying higher debt.
  • Their homes can no longer be used as a revolving ATM machine.
  • And government spending is likely to slow to a standstill.

But before jumping on the “We’re heading for a slow growth economy” bandwagon, there are a few insights we’d like to share.

The last few decades of economic expansion have been the aberration, rather than the norm. Given that there have been only three recessions in the past 28 years, the economic expansions that started in 1982, 1991, and 2001 were three of the longest in US history.

It’s important to recognize that disinflation and falling long-term interest rates have played a vital role in helping extend these recent economic cycles. Without the headwinds of significant inflation or the sharp cyclical swings in interest rates of the 1960s and ’70s, the economic shock absorbers prevented more modest bumps in the road from derailing the economy

Our Shock Absorbers Have Worn Out
But with long-term bond yields and interest rates now at 50-year lows, the economic shock absorbers are worn out. There is simply no more liquidity—from either the consumer or the Federal Reserve—to cushion the economic ride.

And with government debt and deficit levels so high, we’re far more likely to see higher (rather than lower) inflation in the future.

In other words, the odds favor a more cyclical economy over the coming years, and economic expansions that are closer to the norm.

As shown below, the average length of past economic recoveries (the time between the official end of one recession and the beginning of the next) is just 3.8 years. And with the current recovery starting in June 2009, this expansion could conceivably be at or even past the mid-point.

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The US has experienced slow growth a number of times in the past. The years between 1954 and 1961 were perceived as a slow-growth period, even though stocks generally did well. The entire decade of the 1970s through the early ’80s was especially noted for slow growth—as well as a lousy stock market.

By comparison, the 18 years from 1983 to 2000 averaged a healthy 3.7% annual GDP growth, while the 13 years between 1970 and 1982 experienced average growth more than a full percentage point lower, at 2.5%.

NEXT: More Frequent Recessions, More Bear Cubs

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But in reality, past slow-growth periods generally haven’t resulted from 1% or even 2% GDP growth. In fact, as shown in the year-by-year US GDP chart below, it is very rare for economic growth to dip under 2% except when the economy falls into recession (denoted by shaded bars).

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What this means is that “slow growth” is not really caused by, well, slow growth, but by more frequent recessions when growth falls to zero or turns negative for a number of quarters.

More Frequent Recessions, More Bear Cubs
If we’re going to see a more cyclical economy, that means more frequent bear markets. The good news is that bear markets will likely be milder than the past two generational bears (which took the S&P 500 Index down 49.1% and 56.8%, respectively).

Managing risk in the coming decade will be every bit as important as the past decade. And it will be far more important than during the 1990s, when investors could seemingly throw money at any sector and concept of stock and come out on top.

Here’s where the technical and fundamental evidence points in the current market/economic cycle...

We’ve previously discussed the folly of trying to be a contrarian simply because an increasing number of investors or advisors are changing to a favorable outlook for the market. During past bull markets, a sizeable majority of investors and advisors are usually bullish during the middle stages of a bull market’s gain. They are just notably wrong at important turning points.

Chief executive officers at the nation’s companies, on the other hand, often turn decisively positive very quickly near the end of a recession, and then start to falter in confidence as the recovery ages, profit margins narrow and revenue growth slows. So it’s a healthy sign that the CEO Confidence Survey just hit the highest level in almost seven years.

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Consumer confidence faltered in the latest survey, which isn’t surprising given the news from Japan and the equally disastrous headlines about the budget showdown on Capital Hill.

But when you look at the spread between “Future Expectations” and “Present Situation” surveys, we’re not seeing the relative deterioration in consumer outlook that would precede economic trouble ahead.

While we are concerned about developing inflation pressures later this year, or in 2012, we also believe a significant part of this run-up in oil and commodity prices is being driven by emotions, rather than supply and demand. Oil speculation is being fueled not only by political turmoil in Egypt, Libya, and the Middle East, but also by antinuclear sentiment after Japan’s tsunami.

There is likely a $20 to $25 “emotional premium” in the price of oil right now, which could quickly evaporate under the right circumstances. And if lofty commodity prices are a result of hoarding, we might also see a positive downward correction there too.

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