There is plenty to be worried about these days. Outside of Europe, Iran, China and taxes, it appears we are now faced with a slowing economy. Over the past few weeks, we have seen economic and earnings data disappoint versus expectations. Although it appears that the economy is slowing, it can be beneficial to understand the economic cycle to better understand what is truly happening.
The typical economic cycle lasts between 5-7 years. The textbook definition of a business cycle includes four stages: Expansion, Prosperity, Contraction and Recession. Although I may not be textbook in my thinking, I like to divide economic cycles into 7 stages: Peak, Contraction (or Recession), Trough, Recovery, Expansion, Euphoria (then Peak again).
During the Recovery phase, we typically see companies experience significant growth, not because the economy is completely healed, but rather because the growth is being compared to extreme lows (the Trough). Although this growth is welcomed by both individuals and the market, it is typically unsustainable. For example, for the last several quarters we have seen many large cap companies grow earnings by 25 – 50%. During a Recovery, the majority of this growth is achieved by extreme cost cutting and margin expansion combined with a moderate amount of revenue growth.
As the economy begins to heal, we begin to transition to the Expansion phase of an economic cycle. Although less exciting, this is typically the longest phase of an economic cycle. During this period we typically experience earnings growth, but at a slower pace. This is the phase we believe the market is now entering.
Quite often, the transition from Recovery to Expansion is met with much pessimistic volatility. While this transition is taking place, investors still have vivid memories of the past contraction. As the recovery slows, skeptics are able to pinpoint leading indicators that are showing signs of weakness. These factors help to create the “Wall of Worry” that the markets so typically climb.
The good news for our clients is that high-quality, dividend paying stocks will often outperform during an expansionary phase. This occurrence is typically due to earnings growth, dividend yield and rising interest rates, which can harm the weaker, over-leveraged companies. It is also common for high-quality fixed income to underperform during the expansionary period, again due to rising interest rates.
Although the negatives continue to grow by the day, we continue to believe the “double dip” is unlikely. We feel the positive sloping yield curve, absence of inflation, pristine corporate balance sheets and strong corporate earnings growth will provide for a normal, albeit bumpy, transition from Recovery to Expansion.
Michael Ziemer, CFP®