,” Newsweek, September 19, 1966, p. 92.2Peter Lynch, One Up on Wall Street, New York: Penguin Books, 1989, p. 14.207Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
208
PART 3 How the Economic Environment Impacts Stocks
The economist’s address is highly optimistic. He predicts that thereal gross domestic product of the United States will increase over 4 percent during the next four quarters, a very healthy growth rate. There willbe no recession for at least three years, and even if one occurs after that,it will be very brief. Corporate profits, one of the major factors drivingstock prices, will increase at double-digit annual rates for at least thenext three years. To boot, he predicts that a Republican will easily winthe White House in next year’s presidential elections, a situation obviously comforting to the overwhelmingly conservative audience. Thecrowd obviously likes what it hears. Their anxiety is quieted, and manyare ready to recommend that their clients increase their stake in stocks.The time of this address is the summer of 1987, with the stock market poised to take one of its sharpest falls in history, including therecord-breaking 23 percent decline on October 19, 1987. In just a fewweeks, most stocks can be bought for about half the price paid at thetime of the address. But the biggest irony of all is that the economist isdead right in each and every one of his bullish economic predictions.The lesson is that the markets and the economy are often out ofsync. It is not surprising that many investors dismiss economic forecastswhen planning their market strategy. The substance of Paul Samuelson’sfamous words, cited at the beginning of this chapter, still remains truemore than 40 years after they were first uttered.But do not dismiss the business cycle too quickly when examiningyour portfolio. The stock market still responds quite powerfully to changesin economic activity. The reaction of the S&P 500 Index to the business cycleis displayed in Figure 12-1. Although there were many “false alarms”when a substantial market decline was not followed by a recession, stocksalmost always fell prior to a recession and rallied rigorously at signs of animpending recovery. If you can predict the business cycle, you can beat thebuy-and-hold strategy that has been advocated throughout this book.But this is no easy task. To make money by predicting the businesscycle, one must be able to identify peaks and troughs of economic activity before they actually occur, a skill very few if any economists possess.Yet business cycle forecasting is a popular Wall Street endeavor not because it is successful—most of the time it is not—but because the potential gains are so large.
WHO CALLS THE BUSINESS CYCLE?It is surprising to many that the dating of business cycles is not determined by any of the myriad government agencies that collect data on
CHAPTER 12 Stocks and the Business Cycle
FIGURE
209
12–1
S&P 500 Index, Earnings, and Dividends during the Business Cycle, 1940 through December 2006
the economy. Instead, the task falls to the National Bureau of EconomicResearch (the NBER), a private research organization founded in 1920for the purpose of documenting business cycles and developing a seriesof national income accounts. In the early years of its existence, the bureau’s staff compiled comprehensive chronological records of thechanges in economic conditions in many of the industrializedeconomies. In particular, the bureau developed monthly series on business activity for the United States and Great Britain back to 1854.In a 1946 volume entitled Measuring Business Cycles, Wesley C.Mitchell, one of the founders of the bureau, and Arthur Burns, arenowned business cycle expert who later headed the Federal ReserveBoard, gave the following definition of a business cycle:Business cycles are a type of fluctuation found in the aggregate economicactivity of nations that organize their work mainly in business enterprises:
210
PART 3 How the Economic Environment Impacts Stocks
a cycle consists of expansion occurring at about the same time in manyeconomic activities, followed by similarly general recessions, or contractions, and revivals that merge into the expansion phase of the next cycle;this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years and theyare not divisible into shorter cycles of similar character.3
It is commonly assumed that a recession occurs when real gross domestic product (GDP), the most inclusive measure of economic output,declines for two consecutive quarters. But this is not necessarily so. Although this criterion is a reasonable rule of thumb for indicating a recession, there is no single rule or measure used by the NBER. Rather thebureau focuses on four different series to determine the turning points inthe economy: employment, industrial production, real personal income,and real manufacturing and trade sales.The Business Cycle Dating Committee of the National Bureau ofEconomic Research confirms the business cycle dates. This committeeconsists of academic economists who are associated with the bureau andwho meet to examine economic data whenever conditions warrant.Over the entire period from 1802 through 2006, the United States has experienced 46 recessions, and these recessions have averaged nearly 19months in length, while expansions have averaged 34 months.4 Thismeans that, over these 205 years, almost slightly over one-third of thetime the economy has been in a recession. However, since World War II,there have been 10 recessions, averaging 10 months in length, while theexpansions have averaged 66 months. So in the postwar period, theeconomy has been in a recession less than one-seventh of the time, farless than the prewar average.The dating of the business cycle is of great importance. The designation that the economy is in a recession or an expansion has political aswell as economic implications. For example, when the bureau called theonset of the 1990 recession in July rather than August, it raised quite afew eyebrows in Washington. This was so because the Bush administration had told the public that the Iraqi invasion of Kuwait and the surgein oil prices were responsible for the economic recession. This explanation was undermined when the bureau actually dated the onset of the re3
Wesley C. Mitchell and Arthur Burns, “Measuring Business Cycles,” NBER Reporter, 1946, p. 3.The data from 1802 through 1854 are taken from Wesley C. Mitchell, Business Cycles: The Problemand Its Setting, Studies in Business Cycles No. 1, Cambridge, Mass.: National Bureau of EconomicResearch (NBER), 1927, p. 444. The data on U.S. recessions are taken from the NBER’s Web site(www.nber.org), which lists business cycles from 1854 onward.
4
CHAPTER 12 Stocks and the Business Cycle
211
cession a month earlier. Similarly the 2001 recession began in Marchwhen technology spending dropped sharply and well before the 9/11terrorist attacks.The Business Cycle Dating Committee is in no rush to call the turning points in the cycle. Never has a call been reversed because of new orrevised data that have become available—and the NBER wants to keepit that way. As Robert E. Hall, current chair of the seven-member Business Cycle Dating Committee indicated, “The NBER has not made anannouncement on a business cycle peak or trough until there was almostno doubt that the data would not be revised in light of subsequent availability of data.”5Recent examples of the NBER’s dating make the point: The July1981 peak was not called until early January 1982, while the Novembertrough was not dated until July 1983. The July 1990 peak of the expansion was not officially called until 9 months later. The March 1991 troughwas not designated until December 1992, 21 months later, and the March2001 peak was not called until late in November. And the trough of thatrecession in November 2001 was not called until July 2003. Clearly, waiting for the bureau to designate business cycles is far too late to be of anyuse in timing the market.
STOCK RETURNS AROUND BUSINESS CYCLE TURNING POINTSAlmost without exception, the stock market turns down prior to recessions and rises before economic recoveries. In fact, out of the 46 recessions from 1802, 42 of them, or more than 9 out of 10, have beenpreceded (or accompanied) by declines of 8 percent or more in the totalstock returns index. Two exceptions followed World War II: the 1948 to1949 recession that immediately followed the war and the 1953 recession, when stocks fell just shy of the 8 percent criterion.The return behaviors for the 10 post–World War II recessions aresummarized in Table 12-1. You can see that the stock return indexpeaked anywhere from 0 to 13 months before the beginning of a recession. The recessions that began in January 1980 and July 1990 are amongthe very few in U.S. history for which the stock market gave no advancewarning of the economic downturn.As the Samuelson quote at the beginning of this chapter indicates,the stock market is also prone to false alarms, and these have increasedin the postwar period. Excluding the war years, when declining stock5
Robert Hall, “Economic Fluctuations,” NBER Reporter, Summer 1991, p. 1.
212
PART 3 How the Economic Environment Impacts Stocks
TABLE
12–1
Recessions and Stock Returns
Recession
Peakof StockIndex(1)
1948-1949 May 19481953-1954 Dec 19521957-1958 Jul 19571960-1961 Dec 1959Nov 196819701973-1975 Dec 1972Jan 198019801981-1982 Nov 19801990-1991 Jul 1990Aug 20002001
Peakof BusinessCycle(2)
Lead TimeBetweenPeaks(3)
Decline inStock Indexfrom (1) to (2)(4)
Maximum 12Month Declinein Stock Index(6)
Nov 1948Jul 1953Aug 1957Apr 1960Dec 1969Nov 1973Jan 1980Jul 1981Jul 1990Mar 2001
671413110807
-8.91%-4.26%-4.86%-8.65%-12.08%-16.29%0.00%-4.08%0.00%-22.94%
-9.76%-9.04%-15.32%-8.65%-29.16%-38.80%-9.55%-13.99%-13.84%-26.55%
Average
5.7
-8.21%
-17.47%
markets coincided with expanding war economies, there have been 12episodes since 1802 when the cumulative returns index for stocks fell by8 percent or more, but the drop was not then followed by a recessionwithin the next 12 months. This happened five times in the nineteenthcentury and seven times in the twentieth century. All the occasions inthis century have occurred since World War II.Declines greater than 10 percent in the Dow Jones Industrial Average during the postwar period that were not followed by recessions arelisted in Table 12-2. The 1987 decline of 35.1 percent from Augustthrough early December is the largest decline in the near-200-year history of stock returns data after which the economy did not fall into a recession. Chapter 16 will discuss the 1987 stock crash and explain why itdid not lead to an economic downturn.The trough in the stock return index and the trough in the NBERbusiness cycle are compared in Table 12-3. The average lead time between a market upturn and an economic recovery has been 4.8 months,and in 8 of the 10 recessions, the lead time has been in an extremely narrow range of 4 to 6 months. This compares to an average of 5.7 monthsthat the peak in the market precedes the peak in the business cycle; thispeak market to peak economy lead time also has shown much greater
CHAPTER 12 Stocks and the Business Cycle
TABLE
213
12–2
False Alarms by Stock Market (Postwar Declines of 10 Percent or More in the DowJones Industrial Average When No Recession Followed within 12 Months)
variability and less predictability than the market trough to economytrough lead time.There are two ways to treat the 2000 to 2002 bear market. The firstinterpretation is that there was one bear market that peaked on a total return basis on September 1, 2000, and bottomed on October 9, 2002, for aloss of 47.4 percent, or there were two bear markets: a drop of 35.7 percent from September 1, 2000, through September 21, 2001, 10 days afterthe 9/11 terrorist attacks, then a subsequent rally of 22.1 percent toMarch 19, 2002, and finally another bear market of 33.0 percent, endingin October.The second interpretation is more in line with the economic data,which show that the 2001 recession that began in March ended in November, two months after the stock market began its rebound. Underthis interpretation, however, the second leg of the bear market was thesecond largest decline in U.S. history (after the 35.1 percent drop that accompanied the stock crash of 1987), which did not end in a recession.66To be sure, there was some controversy about the NBER timing of the 2001 recession. The economydid bounce back from the September 2001 terrorist attacks by year-end, but in the ensuing monthsthe recovery was very weak by historical norms and GDP growth in the fourth quarter of 2002 wasessentially zero. As noted earlier in this chapter, the NBER did not indicate that November 2001ended the 2001 recession until July 2003, when the economy had noticeably picked up. The stockmarket rally that began in October 2002 did precede the subsequent acceleration of economicgrowth, but it did not signal the end of the NBER-dated recession.
214
PART 3 How the Economic Environment Impacts Stocks
TABLE
12–3
Expansion and Stock Returns, 1948 through December 2001
Recession
Troughof StockIndex(1)
1948-1949 May 19491953-1954 Aug 19531957-1958 Dec 19571960-1961 Oct 1960Jun 197019701973-1975 Sep 1974Mar 198019801981-1982 Jul 19821990-1991 Oct 1990Sep 20012001
Troughof BusinessCycle(2)
Lead TimebetweenTroughs(3)
Rise inStock Indexfrom (1) to (2)(4)
Oct 1949May 1954April 1958Feb 1961Nov 1970Mar 1975Jul 1980Nov 1982Mar 1991Nov 2001
5944564452
15.59%29.13%10.27%21.25%21.86%35.60%22.60%33.13%25.28%9.72%
AverageStd. Dev.
4.8 22.44%1.81 8.81%
It is important to note that by the time the economy has reached theend of the recession, the stock market has risen 22.4 percent on average.Therefore, an investor waiting for tangible evidence that the businesscycle has hit bottom has already missed a very substantial rise in themarket.
GAINS THROUGH TIMING THE BUSINESS CYCLEThe excess returns of investors who can time their investment strategyin relation to the peaks and troughs in economic activity are displayed inTable 12-4. Since stocks fall prior to a recession, investors want to switchout of stocks and into Treasury bills before the business downturn begins—if they can identify the turning point—and return to stocks whenprospects for economic recovery look good. Switching returns are defined as the returns to an investor who switches from stocks to bills agiven number of months before (or after, if his or her predictions are notaccurate) a business cycle peak and switches back to stocks a given num-
CHAPTER 12 Stocks and the Business Cycle
215
ber of months before (or after) a business cycle trough. Buy-and-hold returns are defined as the returns from holding the market through the entire business cycle. Excess returns are defined as switching returns minusthe returns from the buy-and-hold strategy.7Over the entire period from 1802 through 2006, the excess returnsare minimal over a buy-and-hold strategy if investors switch into billsexactly at the business cycle peak and into stocks exactly at the businesscycle trough. In fact, investors switching into bills just one month afterthe business cycle peak and back into stocks just one month after thebusiness cycle trough would have lost 0.6 percent per year compared tothe benchmark buy-and-hold strategy.Interestingly, it is more important to be able to forecast troughs ofthe business cycle than it is peaks. An investor who buys stocks beforethe trough of the business cycle gains more than an investor who sellsstocks an equal number of months before the business cycle peak.The maximum excess return of 4.8 percent per year is obtained byinvesting in bills four months before the business cycle peaks and instocks four months before the business cycle troughs. The strategy ofswitching between bills and stocks gains almost 30 basis points (30⁄100 of a7
The returns of the buy-and-hold strategy are adjusted to reflect the same level of market risk as thebuy-and-hold strategy.
TABLE
12–4
Switching Returns (Percent) Minus Buy-and-Hold Returns (Percent) around Business Cycle TurningPoints, 1802 through December 2006
Switching fromBills to Stocksbefore Trough
Switching from Stocks to Bills before Peaks4 month3 month2 month1 month
Switching from Stocks to Bills after Peaks1 month2 month3 month4 month
4 month
4.8
4.0
4.2
4.1
3.3
2.7
2.1
2.2
1.9
3 month
4.0
3.3
3.5
3.3
2.6
1.9
1.4
1.5
1.3
2 month
3.3
2.6
2.8
2.6
1.9
1.2
0.7
0.8
0.7
1 month
2.5
1.8
2.0
1.8
1.1
0.5
0.0
0.1
0.0
1.9
1.2
1.4
1.2
0.5
-0.2
-0.7
-0.6
-0.7
1 month
1.5
0.8
1.0
0.8
0.1
-0.6
-1.1
-1.0
-1.1
2 month
0.9
0.2
0.4
0.2
-0.5
-1.1
-1.7
-1.6
-1.7
3 month
0.5
-0.2
0.0
-0.2
-0.9
-1.5
-2.1
-2.0
-2.1
4 month
0.3
-0.4
-0.2
-0.3
-1.1
-1.7
-2.2
-2.1
-2.2
At TroughSwitching fromBills to Stocksafter Trough
AtPeak
216
PART 3 How the Economic Environment Impacts Stocks
percentage point) in average annual returns for each week during thefour-month period in which investors can predict the business cycleturning point.The extra returns from successfully forecasting the business cycleare impressive. An increase of 1.8 percent per year in returns, achievedby predicting the business cycle peaks and troughs only one month before they occur, will increase your wealth by over 60 percent over anybuy-and-hold strategy over 30 years. If you can predict four months inadvance, the annual increase of 4.8 percent in your returns will morethan triple your wealth over the same time period compared to a buyand-hold strategy.
HOW HARD IS IT TO PREDICT THE BUSINESS CYCLE?Billions of dollars of resources are spent trying to forecast the businesscycle. The previous section showed that it is not surprising that WallStreet economists desperately try to predict the next recession or upturnsince doing so dramatically increases returns. But the record of predicting exact business cycle turning points is extremely poor.Stephen McNees, vice president of the Federal Reserve Bank ofBoston, has done extensive research into the accuracy of economicforecasters’ predictions. He claims that a major factor in forecast accuracy is the time period over which the forecast was made. He concludes, “Errors were enormous in the severe 1973–1975 and 1981–1982recessions, much smaller in the 1980 and 1990 recessions, and generally quite minimal apart from business cycle turning points.”8 But it isprecisely these business cycle turning points that turn a forecaster intoa successful market timer.The 1974 to 1975 recession was particularly tough for economists.Almost every one of the nearly two dozen of the nation’s top economistsinvited to President Ford’s anti-inflation conference in Washington inSeptember 1974 was unaware that the U.S. economy was in the midst ofits most severe postwar recession to date. McNees, studying the forecasts issued by five prominent forecasters in 1974, found that the medianforecast overestimated GNP growth by 6 percentage points and underestimated inflation by 4 percentage points. Early recognition of the 1974recession was so poor that many economists “jumped the gun” on the
8Stephen K. McNees, “How Large Are Economic Forecast Errors?” New England Economic Review,July/August 1992, p. 33.
CHAPTER 12 Stocks and the Business Cycle
217
next recession, which didn’t strike until 1980 while most economiststhought it had begun early in 1979.From 1976 to 1995, Robert J. Eggert and subsequently RandellMoore have documented and summarized the economic forecasts of anoted panel of economic and business experts. These forecasts are compiled and published in a monthly publication entitled Blue Chip Economic Indicators.In July 1979, the Blue Chip Economic Indicators report said that astrong majority of forecasters believed that a recession had alreadystarted—forecasting negative GNP growth in the second, third, andfourth quarters of 1979. However, the NBER declared that the peak ofthe business cycle did not occur until January 1980 and that the economyexpanded throughout 1979.By the middle of the next year, forecasters were convinced that a recession had begun. But as late as June 1980 the forecasters believed thatthe recession had started in February or March and would last about ayear, or about one month longer than the average recession. This prediction was reaffirmed in August, when the forecasters indicated that theU.S. economy was about halfway through the recession. In fact, the recession had ended the month before, in July, and the 1980 recessionturned out to be the shortest in the postwar period.Forecasters’ ability to predict the severe 1981 to 1982 recession,when unemployment reached a postwar high of 10.8 percent, was nobetter. The headline of the July 1981 Blue Chip Economic Indicators report read, “Economic Exuberance Envisioned for 1982.” Instead, 1982was a disaster. By November 1981 the forecasters realized that theeconomy had faltered, and optimism turned to pessimism. Mostthought that the economy had entered a recession (which it had donefour months earlier), nearly 70 percent thought that it would end bythe first quarter of 1982 (which it would not, instead tying the recordfor the longest postwar recession, ending in November), and 90 percent thought that it would be mild, like the 1971 recession, rather thansevere—wrong again!In April 1985, with the expansion well underway, forecasters werequeried as to how long the economy would be in an expansion. The average response was for another 20 months, which would put the peak atDecember 1986, more than 3.5 years before the cycle actually ended.Even the most optimistic forecasters picked spring 1988 as the latest datefor the next recession to begin. This question was asked repeatedlythroughout 1985 and 1986, and no forecaster imagined that the 1980s expansion would last as long as it did.
218
PART 3 How the Economic Environment Impacts Stocks
Following the stock market crash of October 1987, forecasters reduced their GNP growth estimates of 1988 over 1987 from 2.8 percent to1.9 percent, the largest drop in the 11-year history of the survey. Instead,economic growth in 1988 was nearly 4 percent, as the economy grewstrongly despite the stock market collapse.As the expansion continued, belief that a recession was imminentturned into the belief that prosperity was here to stay. The continuing expansion fostered a growing conviction that perhaps the business cyclehad been conquered—by either government policy or the “recessionproof” nature of our service-oriented economy. Ed Yardeni, senior economist at Prudential-Bache Securities, wrote a “New Wave Manifesto” inlate 1988, concluding that self-repairing, growing economies were likelythrough the rest of the decade.9 On the eve of one of the worst worldwide recessions in the postwar era, Leonard Silk, senior economics editor of the New York Times stated in May 1990 in an article entitled “IsThere Really a Business Cycle?”:Most economists foresee no recession in 1990 or 1991, and 1992 will be another presidential year, when the odds tip strongly against recession.Japan, West Germany, and most of the other capitalist countries of Europeand Asia are also on a long upward roll, with no end in sight.10
By November 1990, Blue Chip Economic Indicators reported that themajority of the panel believed the U.S. economy had already slipped, orwas about to slip, into a recession. But by then, not only had the economy been in recession for four months, but the stock market had alreadyhit its bottom and was headed upward. Had investors given in to theprevailing pessimism at the time when the recession seemed confirmed,they would have sold after the low was reached and stocks were headedfor a strong three-year rally.The record 10-year expansion of the U.S. economy from March 1991through March 2001 again spawned talk of “new era economics” andeconomies without recession.11 Even in early 2001, the vast majority offorecasters did not see a recession. In fact, in September 2001, just beforethe terrorist attack, only 13 percent of the economists surveyed by BlueChip Economic Indicators believed the United States was in a recessioneven though the NBER subsequently indicated that the United States recession had begun six months earlier in March.12 And by February 2002,9
“New Wave Economist,” Los Angeles Times, March 18, 1990, Business Section, p. 22.Leonard Silk, “Is There Really a Business Cycle?” New York Times, May 22, 1992, p. D2.11See Steven Weber, “The End of the Business Cycle?” Foreign Affairs, July/August 1997.12Blue Chip Economic Indicators, September 10, 2001, p. 14.10
CHAPTER 12 Stocks and the Business Cycle
219
less than 20 percent thought the recession had ended in 2001 althoughthe NBER eventually dated November 2001 as the end of the recession.13Once again, economists have been unable to call the turning point of thebusiness cycle until well after the date has passed.
CONCLUSIONStock values are based on corporate earnings, and the business cycle is aprime determinant of changes in these earnings. The gains of being ableto predict the turning points of the economic cycle are enormous, yetdoing so with any precision has eluded economists of all persuasions.Despite the growing body of economic statistics, predictions are not getting much better over time.The worst course an investor can take is to follow the prevailingsentiment about economic activity. The reason is that it will lead the investor to buy at high prices when times are good and everyone is optimistic, and sell at the low when the recession nears its trough andpessimism prevails.The lessons to investors are clear. Beating the stock market by analyzing real economic activity requires a degree of prescience that forecasters do not yet have. Turning points are rarely identified until severalmonths after the peak or trough has been reached. By then, it is far toolate to act in the market.
13
Blue Chip Economic Indicators, February 10, 2002, p. 16.
This page intentionally left blank
13
CHAPTER
WHEN WORLD EVENTS IMPACTFINANCIAL MARKETSI can predict the motion of heavenly bodies, but not the madness ofcrowds.ISAAC NEWTON
As the sun rose over New York City on a beautiful Tuesday morning,September 11, 2001, traders expected a dull day on Wall Street. Therewas no economic data coming out of Washington, nor any earnings releases scheduled. The previous Friday the markets had fallen on a horrible employment report, but on Monday the markets had bounced backslightly.The U.S. equity markets had not yet opened, but contracts on theS&P 500 Index futures had been trading all night as usual on the electronic Globex exchange. The futures markets were up, indicating thatWall Street was expecting a firm opening. But then a report came at 8:48a.m. on what was to be one of the most fateful days in world history: aplane crashed into the World Trade Center Towers. The pattern of trading over the next 27 minutes, before the market closed,