Most money advice is naturally connected with the state of the economy, not just client objectives. But how many advisors can reliably foresee the economic future when they give advice, even in the near term, in the current environment?
June 30, 2009, marked the end of the recession that started in December 2007, according to the National Bureau of Economic Research, which determines when economic expansions and contractions officially begin and end. If the bureau is to be believed, we are already into the third year of a recovery. In the recent past, this has roughly marked the midpoint of business cycles that have lasted about five to seven years. The question is, can we believe the NBER and formulate client advice based on its "official" opinion?
To answer the question, it is useful to begin with a simple description of what the lowest point of a business cycle generally looks like. At such a trough, GDP should exhibit the effects of a cumulative economic decline. Businesses will have cut most production as they anticipate low demand and typically sell off their built-up inventory. Lowered production means higher unemployment, since businesses will cut the labor force to prepare for the economic slowdown.
In turn, the increase in unemployment would also reflect lowered incomes and consumption, low tax revenues, low consumer confidence, etc. The trough would also be marked by a regime of low interest rates due to sluggish demand, high bond prices and lower stock prices (though stocks would be rising because of their role as a leading indicator). This is the nature of an economic nadir.
As the economy turns around, it is changed by and changes all the trough conditions. The low interest rates lead to business borrowing, since, at the low cost of capital, many businesses find previously shelved project NPVs attractive and acceptable. Such capital expenditures by business lead to a new round of hiring (decreasing unemployment), increasing income, production, consumption and taxes. These increases continue through the business cycle till the economy peaks-at a state of high employment, production, income, consumption and tax revenues as well as high interest rates. Bond markets are at their lowest while stock markets have peaked.
This is the standard understanding of GDP business cycles. It implies that at the early stages of a growth cycle, we should be able to observe all these indications-a state of increasing production, income, consumption, etc.-along with increases in stocks and decreases in bond prices. Going back to our original question-Can the NBER be believed when it claims that the last two years were the early stages of a growth cycle?-we need validation from what is actually happening in the economy.
Early Stage Growth Indicators: MIA Or A Double Dip?
The current GDP growth rate is a meager 2%, hardly the typical 3.5%-5% associated with early and robust growth stages. Furthermore, businesses have been particularly reticent about borrowing for capital expenditures even though interest rates still languish at historic lows. Thus, we are not witnessing either an increase in production or the subsequent increases in employment, income, etc., that typically result in robust growth in the early phase. Furthermore, new housing starts are down (not up, as they should be). Interest rates have not moved up. And consumer confidence is still near historic lows (and declining).
In other words, besides the stock market, most indicators (leading, lagging or coincidental) reflect a trough, not the early stages of a growth cycle.
This is a huge problem for the investment advisory community. Is the NBER correct about the recovery? If it is, advisors should not only be open to aggressive investing, but should also have placed clients in tactical allocation portfolios with aggressive equity components such as small cap, emerging markets, growth and consumer cyclical, credit cyclical, etc., since such securities do best in the early growth phase. But basing money advice on the belief that the NBER knows best can be disastrous to both clients and advisors alike.
What if the NBER is wrong? What if the economy is not actually recovering and we are instead getting ready for another dip? Advisors who put their faith in speculative equities would be putting their clients in harm's way. Not only would investors see crashing portfolio values, but the government could no longer take corrective action. The feds could not stimulate the economy through monetary policy because they couldn't reduce interest rates that were already near zero.
A double dip would also lead businesses to further cut their labor force. The already staggering unemployment rate would again increase. That could be the last straw on the camel's back. Or if not that, another price plunge in the housing market. The housing bust that started in late 2006 is already the worst on record (even worse than that of the Great Depression), and another downward spiral would mean that more precarious mortgage-based loans could default. The banks holding the mortgages would have to add further bad debt to their off-balance-sheet inventory. The banks have so far been able to hide these loans, but a further decline in the housing sector would force them to start reconciling the bad debt, and that would surely lead to another collapse in this sector.
Thus, it is vital for us to answer the central question regarding this stage of the recovery. If the NBER is correct, it is business as usual. If it's wrong, then all hell may break loose for advisors who had placed their bets on its prognosis. Prudent advisors will be proactive-basing any course of action on the economy and client risk tolerance levels and weaving risk management techniques into portfolios.
Advisors should especially watch out for a few things. For one, are there any signs of a new downturn in the housing market? If new housing starts declined two to three months in a row, it would be a code red. So would back-to-back months of further initial job loss claims. Either of these two indicators by themselves would be cause enough for concern about a double dip. Together, they could be catastrophic.
Another indicator to watch keenly would be interest rates. We can expect the Fed not to raise interest rates at this point, since such an action could be contractionary and thwart growth. However, we also know that interest rates should start rising to reflect the economic turnaround and the ensuing increase in money demand, mainly by business. If business's demands for money do not increase and money rates remain at or near their abysmally low current levels, then that too would be cause for alarm. Finally, the consumer confidence index would need to show a turnaround as well, showing the public believed in a better future after a period of government and corporate action. That attitude would lead to increased consumer spending, which in turn would stimulate business production and employment.
Advisors wishing to stay a few steps ahead of the competition should watch those four indicators-new housing starts, unemployment, interest rates and consumer confidence-like hawks. At the first sign of danger, they should have time to carry out value protection strategies. The simplest of all proactive techniques would be to construct only very broadly diversified global portfolios using easily traded securities, such as ETFs. Such a tactic would allow advisors to shift quickly and easily among asset classes for reallocation purposes. Alternatively, advisors may take a small position in equity or debt put options-an insurance-like precaution-so that even if the economic read were incorrect (as it could easily be), not all would be lost. Even a small (1%-2%) option put position would go a very long way toward protecting clients against the most harmful downturns. Investors may also reduce the cost of such hedging/insurance by buying puts that are a little bit out of the money.