U.S. Economy: The Rhythm Is Gonna Get You

Includes: DIA, IVV, QQQ, SPY, VTI
by: Eric Parnell, CFA

"No way you can fight it every day

No matter what you say

You know it, the rhythm is gonna get you"

-Gloria Estefan

The U.S. economy has historically moved with rhythm. Every three years on average, the economy would expand. And then for just over a year, the economy would recede. This historical rhythm is important. For just as yin cannot exist without yang, light cannot exist without dark, life cannot exist without death, and good cannot exist without bad, economic growth cannot exist without recessions. By periodically entering into recession, the economy is given the opportunity to cleanse the excesses built up during the last expansion and build a stronger base for the next phase of growth. The time has come today for the economy to enter its latest recessionary phase and cleanse itself anew. And history tells us that while it can provide some market relief today, trying to cheat recessions can bring far greater consequences down the road.

The rhythm of the U.S. economy has been disrupted in recent years. According to the National Bureau of Economic Research (NBER), the historical relationship described above was consistently intact barring rare exception for 128 years from 1854 to 1982. But something dramatically changed over the last 30 years. The idea was fully embraced that through the active implementation of fiscal and monetary policy, the economy could effectively cheat death and enjoy continued growth without recessions. But as life continuously teaches us, consequences accompany the disruption of long-term symbiotic relationships.

The first instance came in 1986. Under normal economic rhythms, the timing was right for the economy to slow that year. And so it was in 1986 that economy growth began to fade. But instead of falling into recession, the fiscal and monetary policy makers managed to ease the economy into a "soft landing". Stocks (NYSEARCA:SPY) celebrated and ramped higher into 1987, which of course culminated in what was the largest single day decline in market history.

The next rhythmic disruption came in 1994. After lowering interest rates aggressively to reduce the depth of the 1990 recession, the Fed acted to ease inflationary pressures by tightening policy. But they were able to tighten slowly enough to avoid a recession. What followed was another freak market environment where the S&P 500 posted unprecedentedly robust back-to-back-to-back-to-back returns of +38% in 1995, +24% in 1996, +39% in 1997 and +42% in 1998.

The economy cheated death once again in 1998. A year following the outbreak of the Asian financial crisis, the recession threat was lapping up against U.S. shores with the Russian ruble crisis and the collapse of Long Term Capital Management. But once again, policy makers intervened by lowering interest rates. And instead of the economy falling into recession, it stabilized. And what followed in the coming months was the expansion of the technology bubble in earnest.

By the turn of the millennium, the U.S. economy had skipped three of the past four recessions. And the excesses that had built up and were never cleansed out of the economy along the way started to bubble over. The markets finally buckled, with stocks falling into their worst decline in a quarter century. And the economy soon followed into recession in 2001 with spillover effects lingering well into 2002. But even after two decades with only one shallow recession leading up to this point, the magnitude of the economic contraction was relatively modest. This once again was thanks to exceptionally aggressive fiscal and monetary policy including interest rates that were locked at well below 2% for roughly three years from 2001 to 2004. Of course, what followed was a massive housing bubble with catastrophic consequences for the global economy.

By 2006, the U.S. economy was showing signs of slowing once again. The Fed, after tightening policy for two years from the summer of 2004 to the summer of 2006, declared it was ceasing to raise rates further citing a pending slowdown in growth that would help diffuse mounting inflation pressures. The intent of policy was to try to achieve yet another economic soft landing. But by this point, the consequence of trying to prevent recessions and the cleansing of economic excesses over the past two plus decades was on the brink of exploding. And so it did in epic fashion starting in 2007 and culminating in the crisis of late 2008.

Despite the economic pain so many have endured over the last few years, the outcome would likely have been vastly worse had it not been for unprecedentedly aggressive fiscal and monetary policy response. Indeed, the recession was severe, but it could have been worse. But by taking such decisive policy action, have we set ourselves up for yet another even more problematic freak market event going forward? This remains to be seen.

But according to the rhythm of the economy, after three years of economic expansion, we have once again reached the point where it is time for a recession. And the stage has clearly been set for such an outcome as we move toward the summer of 2012. Recent U.S. economic data has been increasingly fading, Asian economies are also slowing and Europe is increasingly descending into crisis. But the critical question remains. Will we allow the economy to fall into recession and allow at least some of the excesses that have been built up to this point to be cleansed out of the system? Will we give the economy the chance to get itself more fit and find a better basis from which to generate future growth? Or will policy makers intervene yet again with even more support and stimulus to try to cheat economic death once again? Our latest update on this front will come on Wednesday following the latest Fed meeting. Stay tuned.

The stakes are rising for financial markets. With each successive effort by policy makers to try to smooth over recessions if not bypass them altogether, they prevent the economy from cleansing itself and end up creating consequences that are more complex and severe for the next time around. At some point, the economy will cleanse itself whether policy makers like it or not, and the impact on financial markets including stocks will be severe and unforgiving. Best to get on with it now and let the economy recede, as it will go along way to preventing unintended consequences and a more severe outcome down the road. No matter what policy makers say, the rhythm is eventually gonna get us in the end.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.