Welcome to the Great Moderation 2.0.
That’s what we’ve dubbed the extremely favorable mix of conditions that characterize the current environment: supportive monetary policy, low interest rates, subdued inflation, and an economy that shows no signs of overheating. In our view, this business cycle – which is over seven years old, and the fourth-longest so far – could ultimately prove to be the longest on record.
Last week, we received an additional data point that supports our call for an ongoing economic expansion, with some positive surprises for growth in the second half of the year. Specifically, The Conference Board’s U.S. Leading Economic Index (LEI) increased 0.4% month-over-month in July, the fastest pace in the last three months. In a sign of widespread strength, eight of the LEI’s 10 components improved, led by average weekly manufacturing hours, the yield curve (i.e., the 10-year U.S. Treasury bond yield minus the federal funds rate), and stock prices (i.e., the S&P 500).
In the chart below (Exhibit 1), we plotted the deviation of the LEI from its own trend alongside the year-over-year growth rate of U.S. real gross domestic product (GDP) since 1990. Also, we advanced the LEI by six months to illustrate how it anticipates and serves as a directional indicator of trends in economic activity.
The good news is that the LEI is perking up, suggesting that the U.S. economy is unlikely to contract and will keep growing at a modest pace this year. Indeed, our research shows that the LEI (1%) is well above its average reading (-2%) at the beginning of recessions since 1960.
Right on cue, U.S. real GDP slowed to 1.2% year over year in the second quarter of 2016 – not too hot, not too cold. Consumer spending was strong, but was offset by declining business investment in inventories. While shrinking inventories were a big negative in the second quarter, lean product stockpiles now foreshadow future accumulation, which is positive for prospective production and employment.
Stocks Have Plenty of Room to Run
Assessing the probabilities of economic expansions and recessions is a worthwhile pursuit because it helps equity investors gauge their potential upside and downside risks. During the recession of 1933-1937 (a four-year period), the S&P 500 fell 79%, which equates to a compound annual growth rate (CAGR) of -35% (i.e., the maximum historical downside in recessions). Overall, the miss rate, or percentage of negative returns during contractions, was 62%, meaning stocks dropped in the majority of recessions since 1871.
During the expansion of 1991-2001 (a 10-year period and the longest cycle), the S&P 500 rose 219%, which is a CAGR of 12% (i.e., the maximum historical upside in expansions). More broadly, the hit rate, or percentage of positive returns during expansions, was 90%, indicating equities climbed in the bulk of economic upswings over the past 145 years.
During the current expansion (a seven-year period and the fourth-longest cycle so far), the S&P 500 has rallied 135%, which equals a CAGR of 13% (Exhibit 2).
As we’ve demonstrated, economic regimes are important, and the length of the present cycle will be key for future equity performance. The S&P 500 has attained record highs, but where do we go from here?
A growing chorus of voices is warning of an impending selloff, a deep correction, or even a bear market in stocks. If we’re right about this being at least an extended cycle, history argues that a pullback in share prices should present a buying opportunity to investors.
The bottom line is that the rally in the current expansion (135%) falls short of the gains during the longest cycle (219%) by 83 percentage points, implying plenty of room for upside ahead.
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The S&P 500 Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. The index includes the reinvestment of dividends but does not include fees, expenses or taxes. Indices are unmanaged and cannot be purchased directly by investors.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.