Long-Term Evidence For Nearby Recession

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Includes: QQQ, SPY
by: ESI Analytics Limited

Summary

US economy most likely in very late stage of expansion cycle.

Descriptive analysis of US expansion cycles from 1870 to 2009.

Boom cycle peaks were almost always lagging equities peaks.

Introduction

The US economy and stock market have been booming since the worldwide financial crisis in 2009. How does this compare to recent economic history?

We are going to take a look at the behavior of historic growth cycles in the United States. Moreover, we will explore how cyclical bull markets are related to economic cycles. Last but not least, we will compare the present phase since 2009 to what has been observed historically.

1870-2009 Expansion Cycles

Innovation is a major driver of a positive drift in economic growth, which can be quantified by gross domestic product (GDP). Economic cycles describe fluctuations of the economy around the positive long-term growth trend.

We are utilizing a dataset from the Maddison project. Our focus is directed to boom cycles in the US from 1870 to 2009. A total of 21 distinctive boom cycles in GDP growth occurred during that period. Our bespoke definition of a finished boom cycle is simply a year that records either nominal or real GDP contraction. All 21 boom cycles lasted between 2 years and 11 years. The first chart "Expansionary Cycle Duration" gives a graphical overview of cycle durations since 1870.Cycle Duration

Source: Scienceinvesting

The median duration of an average boom cycle during this period amounts to four years. The maximum duration was 11 years. An expansion lasting 9 years has been recorded in two instances. It occurred during the cycle that started in 1991 and during the current cycle from 2009. The second chart shows the statistical characteristics of the respective cycles from another angle.

All in all, the picture suggests that the current expansionary cycle, since 2009, is very extended in a historical context. Most likely, we find ourselves at a mature stage of the expansionary cycle right now.

Descriptive Cycle Stats Source: Scienceinvesting

Stock Market And Economic Cycles

We analyze time series data for the S&P 500 index spanning back to 1870. The data is provided by Professor Robert J. Shiller of Yale University. We utilize the data in order to find out how US equities behaved around the end of expansionary business cycles in the past.

Not surprisingly, the stock market performed negatively during economic busts. This occurred in 20/21 instances without lag and on one instance with a time lag. Moreover, stocks have been a leading indicator for the economy in the vast majority of business cycle turns. Stocks topped on 17 out of 21 occasions before the economy. Three occasions recorded a parallel top and just one instance recorded a lagging equity market top. The median time frame was a three-month lag between stocks and the economy. The only instance that the stock market topped after the economy occurred during the second world war. That particular instance recorded an economy peak 13 months before the stock market peaked. We treat this event as an outlier due to specific circumstances related to the war.

Descriptive statistics are not pointing out an interesting observation. The time lag between the stock market and economy peaks decreased since the 1980s. The data post the 1980s records many instances below the 25th percentile duration time frame. A couple of instances, 1981 and 1990, showed a roughly parallel peak in stocks and the economy. There was hardly any time lag in both of these instances.

All in all, the data strongly suggest a relationship between economic busts and stock market downturns. Moreover, the stock market peaked usually but not always before the economy topped.

Time Lag Cycle vs Stocks Source: Scienceinvesting

Conclusion

The current economic expansion is most likely at a late stage. Only 1 out of 21 historic time windows recorded a longer economic expansion than the current cycle, which started in 2009. Everything else being equal, this suggests an above 90% probability to enter a recession within the next 18 months. Moreover, a stock market peak is likely to occur slightly before the economic downturn.

If everything else remained equal and history repeats itself, stock market returns will disappoint investors during the next few years.

Disclosure: I am/we are long SPY, INDY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.