The following is a guest post from Dr Glenn Freed and Dr Andrew Berkman.
Fears for the Next Recession
As we slog our way into the second half of the year, economic data has been weak, with jobs, production and GDP growth lagging expectations. Economic conditions globally have been even more worrying, particularly in Europe. Admonitions of the “fiscal cliff” awaiting the US at year-end have further added to concerns about another recession.
The Economic Cycle Research Institute (ECRI), a private institution well-known in the investment management and business executive world, stated that it is clearly on record for forecasting a recession to start by the middle of this year. The stock market has reacted negatively to the perceived economic issues, giving back a good portion of its gains for the year.
When have we heard this story before? Oh yeah, last year. After four good months of stock market returns to begin 2011, economic conditions worsened and the budgetary impasse heightened anxiety. The S&P 500 fell by increasing amounts for five straight months starting in May 2011, culminating in a 7.03% loss in September 2011. Talk of recession circulated in the news. For example, on September 30 of last year ECRI announced that a week earlier they had notified clients that the U.S. economy “was indeed tipping into a new recession.” This economic prediction was based upon “dozens of specialized leading indexes”, including their proprietary “Weekly Leading Index.”
Predicting 10 out of the last 5 recessions
Investors certainly are right to fear recessions. Stock markets tend to fall when the economy suffers. But as we noted in a prior article Understanding Value Investing, moving out of equities in a timely manner is not so straightforward. An old joke is that economists have predicted 10 out of the last 5 recessions. False steps are easy. And even when a recession does occur, the timing is tricky. Not only can markets fall ahead of time, they often recover sharply well before the recession is declared over.
The events of 2011 are a good case in point. Markets fell in anticipation of a recession. But on September 30, the very day that ECRI made public its recession call, the Federal Reserve announced Operation TWIST. The Fed sold short term bonds and bought longer term bonds to bring down longer term interest rates and thus stimulate longer term borrowing and the economy.
While the effectiveness of Operation TWIST is debatable economic data began coming in stronger after it was introduced. Stock markets rallied all the way through the first quarter of this year. Anyone who had moved out of equities on the day of ECRI’s announcement would have captured all the downside and missed all of the subsequent upside. The bigger picture is that timing recessions is tricky indeed. The economy is complex, and events such as government action make forecasting even more difficult.
We do not mean to pick on ECRI. While the Institute is certainly quite vocal and insistent, many other economists were making similar pronouncements last year. We have a lot of respect for the thorough and innovative analysis that ECRI provides. But, like sportscasters whose expert commentary helps fans gain a deeper understanding of the game, but makes them no better able to predict the winner, economists can have highly informed discussions about the markets and economy, but still have a tough time making accurate predictions.
Will the U.S. enter a recession, or will the economy start picking up again? We don’t know. But, any prognostication at this point is an educated guess at best. At some time of course, there will be another recession, and the stock market will suffer. This is part of the “risk” side of the equity risk premium. But over the long term, investors have been compensated for bearing that risk, with recovery periods providing some of the most attractive returns. Investors set their long term allocations accordingly, gauging the trade-off between risk aversion and desire for return. The events of last year offer a lesson on the perils of reacting to uncertain economic forecasts.
Although Dr Freed and Dr Berkman are known experts on the subject matter discussed, the Adviser has not independently verified the accuracy of the content provided.