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?
Business Cycles
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.