It's All About the Economy
September 1, 2012
The most recent GDP figures came out on Friday. Given the timeliness of this data I thought it would be good to write about our economy. If you watched the news or picked up a newspaper in the last five years, you've heard the media constantly discussing the economy. In 2008 and 2009, it was all about the "Great Recession." Now, the news discusses our "sluggish" recovery. So what does this all mean? The answer is a little more complex than the media lets on.
The United States measures our Gross Domestic Product to determine if our economy is growing or contracting. Historically, our economy has grown at an average rate of 3.3% per year over the past seventy years. On August 29, 2012 it was announced that our economy had grown at an annual rate of 1.7% in the second quarter of 2012. As you can see from the data below, we have only had three quarters of economic growth that would be considered above average since the economic recovery began in 2009.
Typically, after a major recession, the economy snaps back much more aggressively. As you can see from the data below, the economy grew at an annualized rate of 11.5% after the 1970 recession. After the 1973-74 recession, we had multiple quarters of above average growth. When you hear that our economy is sluggishly recovering, it's because our current economy has not seen similar upward thrusts as we've seen in prior economic recoveries. Another issue is that our economy has not recovered or surpassed where it was in 2007.
Good Economy Doesn't Necessarily Mean Good Markets:
Probably the best example I can give to illustrate that a good economy doesn't necessarily mean that the markets will follow in kind is the 1987 stock market crash. Below you will find the GDP growth for 1987.
As you can see, the economy was growing at a 4.3% growth rate in the second quarter of 1987. This is above average growth. Yet on a single day, October 19, 1987, the stock market dropped 22.6%. There is debate about why this happened. Most feel that the markets were overvalued and reverted back to where they should have been valued prior to "Black Monday." We refer to this as "reversion to the mean." When the value of an investment is trading at several standard deviations above its average price, you can expect the price to drop back down to average multiples.
Recessions Are Different:
As stated, a good economy doesn't necessarily mean good markets. I think it is a little harder to argue if the economy is contracting then the average company will do better. There will certainly be exceptions, but overall, when the tide goes out, all ships drop. When managing money, it is exceptionally important to understand the economic lay of the land. It is much more important, however, to understand when a recession is upon us rather than if the economy is chugging along.
The textbook definition of a recession is two consecutive quarters of negative economic activity. This is not an official definition backed by our government. In 1975 New York Times article, economic statistician Julius Shiskin made several suggestions for defining a recession. Two consecutive down quarters of GDP caught on as the definition of choice. I find it a virtually useless definition when managing money and trying to mitigate risk.
Below you will find the U.S. GDP Growth Rate from June 2007 through December 2009. Please note that the U.S. economy grew 1.3% in the second quarter of 2008. According to the textbook definition, our recession would not have started until the third quarter of 2008. An announcement of our recession would have required the collection of the data from the fourth quarter of 2008. This would have pushed the announcement well into 2009.
The National Bureau of Economic Research (NBER) made our recession official on December 1, 2008. NBER is a private group of leading economists charged with dating the start and end of economic downturns. In their announcement, they stated that the United States went into our recession in December 2007. Two points should stand out from my prior sentences. The first thing you should have noticed was that NBER named a month in which the recession began, not a quarter. The other issue was how long it took NBER to announce the recession. By December 1st, the S&P 500 had dropped from 1468.36 (December 31, 2007) to 896.24, or 38.96% for the year. No one trying to manage money could use the NBER's announcement as a means to manage risk in their portfolio.
The Chicago Fed National Activity Index (CFNAI):
There are twelve regional Federal Reserve banks throughout the country. Unlike most regional Federal Reserve banks which measure economic activity only in their region, the Chicago Fed created a national activity index. The Chicago Fed releases their data monthly. The index is a weighted average of 85 national economic indicators from four broad categories: 1) production and income; 2) employment, unemployment, and hours; 3) personal consumption and housing; and 4) sales, orders, and inventories.
Below you will find a chart showing the CFNAI from May 1967 through July 2012.
A zero value for the index indicates that the national economy is expanding at its historic trend rate of growth. A negative value indicates below-average growth, whereas a positive value indicates above average growth. If the index moves below a three month average of -0.59, there is a high likelihood that a recession has begun. The CFNAI hit this point in December 2007. It released this information in January of 2008. At this point, it was impossible to know the depth of the recession or the duration. You did know, however, that risk was increasing.
The Chicago Fed National Activity Index is one of many indicators that Polaris uses to help us mitigate risk in your portfolio. If we were to receive a negative reading which indicated we had entered a recession, we would shift some of your stock allocation to bonds and/or money market funds. If we were to receive more confirmation that the recession was deepening we'd continue to shift from stocks to bonds (and/or money market funds), furthering our defensive stance in your portfolio until we saw a change in economic activity.
I'll look forward to sharing other indicators that we actively track to protect and grow your portfolios. In an attempt to not dilute our messages, we will begin sending our updates every two weeks. As always, I welcome your comments.
Jeffrey J. Powell
Managing Partner, Polaris Wealth Advisers, LLC
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