You will not hear much about recessions from the usual sources.


The period from 1986 to 2007 has been called “The Great Moderation.” A whole generation of economists, market players and market commentators grew up and learned about the financial markets under these benign (and unusual) conditions. It is therefore not surprising that much of the longer range prognostications from financial firms, the media and even government agencies are premised on an eventual return to that era of steady trend growth with occasional shallow recessions. Simply stated, most market professionals and commentators are not prepared for the markets as they exist today and are likely to exist in the medium term future (next five years).

Why do we think the markets are different?

The first clue is to take a bird’s eye look at the S&P from the Internet bubble to today.
S&P 500 from 2000 to 2010
S&P 500 Price Source: Yahoo Finance

And compare it to two other recent periods: 1966-1982

S&P 500 from 1966 to 1982

…and 1982-2000

S&P 500 from 1982 to 2000

We have not proven anything yet, but we are certainly starting to get an idea that the current market looks a lot more like the period from 1966-1982 than the glory days of 1982-2000.

But what is causing this secular trend?

For that answer, we need to go to an organization which tends to look at the data from a longer view than most of the financial media and blogosphere.

The folks at ECRI have put out a very enlightening slideshow (click here for the version with notes) which explains in fairly clear language why we are likely to experience more recessions in the near future. To accept their thesis, one needs only a single leap of faith: that business cycles exist. This may not sound radical today but many observers thought the G7 countries had largely conquered the business cycle while Alan Greenspan was Chairman of the Federal Reserve and Europe had joined Central Banks to form the ECB and the Euro.

Theoretical Business Cycle

To summarize the argument, the ECRI slideshow argues that economies move in cycles and, on a fairly regular basis, the swing will take you into negative territory (or a recession). There are only two ways to escape. One is to raise the trend rate of growth (as China has experienced over the past 20 years) to the point where the bottom of the cycle doesn’t reach negative territory. The other (as the US has experienced in the last 20 odd years), is to lower the volatility of growth to the point that the bottom of the cycle only dips slightly into negative territory for a short amount of time.

Since the Developed Economies are unlikely to be able to lift their trend growth rates much above the 1%-3% found in Europe, the US and Japan, the ECRI argues that the only real alternative is to develop policies to achieve the second case of lower volatility around the trend line. Slide 6 of the presentation shows the trends of most of the key coincident indicators in the US and the trend is definitely not towards Chinese rates of growth.

The second case has been achieved from 1986 to 2007 in what has been dubbed “The Great Moderation” which you can see represented in slide 9 below.

Volatility in Growth Figures for the US

Why did we have the “Great Moderation”? And how can we get it back?

ECRI identifies three possible sources of the Great Moderation:

  1. Better Supply Chain Management
  2. Better Monetary Policy Management
  3. Luck

The first two sources are dismissed in fairly short order.

Supply Chain Management, which has indeed improved greatly with rising globalization, has raised incomes around the world. But, as demonstrated in the Great Recession, it has not insulated the global economy from volatility.

Monetary Policy is also shown to lack any discernible prescience without a healthy dollop of hindsight bias.

So that leaves luck or, if you do not like that term, a beneficial set of circumstances. Specifically, the end of the Cold War freed up resources and trade routes and non-synchronized recessions in the US, Europe and Japan ensured that inflationary pressures never got a chance to build. Betting on a repeat in the next few years is not a plausible investment strategy.

So what does that mean for investors?

If, as we believe, the ECRI has its arguments right, we should experience more volatility in growth rather than less in the coming five years and that will translate into more recessions. If that is the case, a traditional Buy and Hold strategy will likely return very flat results (note the S&P 500, 1966-1982 chart).

However, that doesn’t mean there is no money to be made in the financial markets in the coming five years. We feel that using a systematic approach that allows you to shift asset classes as they move in and out of favor will yield a much better result than a simple buy and hold strategy. The IPR system allows you to identify asset classes with good momentum and, on a regular basis, signals when it is time to switch to the new leaders. You can learn more about it at the website.

Filed under: Market Comment

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