Where are We in the Economic Cycle?
There is growing evidence investors are perplexed about where we are in the economic cycle. That is a problem. It always is. Confidence in where we are along the economic cycle rises and falls. However, it is heightened during periods of mid-cycle government intervention (fiscal and monetary) when stock market valuations have already adjusted upward in expectation of a robust post-pandemic recovery. Just now, these valuations are considered stretched. Therefore, a pause or sharp slowing in price appreciation seems likely. It could last some months or a year. Thereafter, as price appreciation stalls while earnings advance, at some point stock prices become attractive again. This is classic mid-cycle market behavior, which should favor value stocks, is brought on by concerns that stock prices will no longer be supported by high price-to-earnings multiples for the following three reasons:
- Tapering: Students of economic cycles recall that the “Roosevelt Recession” of 1937-1938 was brought on by cutting government spending at a time when the economic recovery was still weak enough to be derailed. This came after the 1933 enactment of massive fiscal spending programs which included the Civilian Conservation Corps (CCC). Oh, and the recession was also due to a new social security tax which debuted in 1937. Higher income taxes enacted 1935 were set to start in 1937 as well. Bottom line: tapering of fiscal and monetary policy was enacted too soon for an economy still reeling from the 1929 Great Depression. So, weakness continued to linger eight years later. This should be a red flag warning to inflation hawks who want Fed tapering to begin now. just nine months ago. the New York Times published an article entitled “The Pandemic Depression Is Over. The Pandemic Recession Has Just Begun.” Two days ago, the Wall Street Journal published an article entitled, “U.S. Coronavirus Recession Lasted Two Months, Ended in April 2020, Official Arbiter Says.” The subheading to this heading reads, “The end of economic contraction marks official starting point for the uneven expansion since then.”
- Taxes: Students of economic cycles know that taxes are a drag on the nascent economic recovery. The Biden administration is pushing massive tax hikes. In June of 2021, the Tax Foundation, a nonprofit research group founded in 1937, reported on the impact of Biden’s tax proposal. Bottom line: If you are reading this your taxes are going way up. If you aren’t reading this so are yours, though mostly in the last half of the multi-year proposal. This comes at a time when America needs to do all it can to make home ownership more accessible for people saving for a down payment. FYI: every recovery from a recession since 1945 was brought on by a housing boom. Now we are in trouble if higher prices, taxes and higher borrowing costs squeeze out would-be buyers.
- Inflation and Equity Valuations
When it comes to stocks, valuations change based generally upon many variables, though the main two variables are earnings and a number we multiply by those earnings. This number is called the price-to-earnings multiplier or multiple. Inflation causes price-to-earnings multiples to drop. This drop in multiples can cause a stock trading at $20 to drop to $19.80 even after earnings rise 10%. Here’s how. A company earns one dollar in earnings. It trades at a (price-to-earnings) multiple of twenty. So, $1 x 20 equals $20 per share. Now over the course of a year, the company grows their earnings. In this case, profit growth allows for an increase in earnings of 10 cents or $1.10 in earnings. However, inflation comes along. Investors aren’t so sure this higher earnings number isn’t due to inflation. If so, the company doesn’t look so attractive. No one wants to own a company that cannot grow but for inflation. So, this suspicion causes multiples to drop from 20 to 18. So, a company earning $1.10 trades at just 18 times earnings. The product of these two numbers equals $1.10 x 18 or $19.80 per share. So, you can see how a small loss is derived even though earnings are going up. Generally, price-to-earnings multiples remain steady when inflation remains in the 1.5-2.5% range. Somewhat strangely it is when inflation becomes background noise due to the adjustment of multiples that stocks act as a good inflation hedge. Investors tend to switch their holdings to industry groups that have pricing power to pass on higher input prices to customers.
Much of the ongoing change in the economic cycle (from post-recession launch to mature and slowing margins) is due to decisions at the Fed or in Congress. Without the Federal Reserve Board fighting inflation or stimulating during recessions, risk taking in both the stock and bond markets would be more significant. Imagine unchecked stock market bubbles and busts. That is why the Federal Reserve wants to remind everyone that they have no plans to allow inflationary pressures to get out of control even as they move to reign in the money supply moderately after fighting the pandemic recession with massive fiscal and monetary policies.
Meanwhile, investors aren’t so sure congressional leaders with support from the executive branch government aren’t capable of taxing or stimulating too much, creating bubbles or busts.
Bottom line; expect four things over the next twelve months. More volatility than we’ve seen since October of last year, moderate returns from the equities markets, moderately lower price-to-earnings multiples and the sense that investors will witness better returns in stocks than the fixed-yield bond and bank environment. Why? Both corporate and consumer balance sheets are in fine shape. Inflation should moderate. The world’s central banks have stimulus plans set through 2023. This wouldn’t be the case if longer-term inflation was a serious problem. Therefore, expect the question of where we are in the economic cycle to trend toward mid-cycle orientation. If so, it tells us to underweight defensive stocks, overweight a blend between growth and value stocks and always respect the possibility of black swan events, wage-rate inflation and the overreach of bureaucrats who rarely understand the implication of their decisions.
Vaughn Woods, CFP, MBA
Vaughn Woods Financial Group, Inc.
2226 Avenida De La Playa
La Jolla, CA 92037
Investors should be aware that there are risks inherent in all investments such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0264
FederalReserveHistory.org, The Wall Street Journal (wsj.com), foxbusiness.com, taxfoundation.org, cnbc.com