Column by Jim Flinchum, CIMA, CFP - The Virginian-Pilot, July 23, 2006

It is often said that capitalistic economies like ours are like drunks – they have trouble moving in a straight line! Indeed, we do have a long history of economic “ups & downs”.

According to the National Bureau of Economic Research, which began keeping records in 1854, there have been 31 business cycles, averaging 53 months each. The bottom of the last recession was November of 2001 or 56 months ago. (Furthermore, the year of mid-term elections is historically the worst year for the economy.) Are we overdue for a recession? No!

Since World War II, there have been nine cycles, averaging 61 months each. Since 1982, there have been only two, averaging 118 months. Business cycles are getting longer, primarily because the more volatile causes of recession have been largely stabilized.

Historically, when inventory levels got too high, businesses stopped ordering merchandise, creating big changes in demand. The national inventory level (the inventory of goods on hand for sell to customers) is only 1% of GDP, but it causes a disproportionate 40% of the change in GDP. Today, we have “just-in-time” inventory chains that greatly mitigated these swings. Wisely, few companies maintain large costly inventories anymore.

Another factor causing large swings in the economy was the way homes were purchased. Until 1978, interest rates on deposits were largely controlled by regulation. When depositors could earn higher interest elsewhere, such as in bonds, traditional lenders had no money to lend, and home sales plummeted. Today, mortgage lending continues throughout the business cycle, even at higher rates. Stabilizing this swing has significantly lengthened the business cycle.

In addition, we have diversified our customer base by selling much more overseas. The increasing share of our economy that supplies the foreign markets has diversified demand for our products, making our production less vulnerable to changes from US customers alone.

Few economists worry about a genuine recession, which is often described as two consecutive quarters of negative GDP growth. More accurately, it is a recurring period of absolute decline in employment, income, trade and output across many sectors of the economy. Either way, we cannot say we’re in recession until we’ve been there too long already.

Nonetheless, you can expect to hear more about a “recession” later in the year. Economists now worry about growth recessions, which is a slowdown in the rate of growth of the economy but not an actual or absolute decline. It is an important distinction that examines the difference between the economic strength we have, compared to what we could have (similar to a straight A student earning only C’s).

Most US companies have enjoyed eleven consecutive quarters of growth above 10%. First quarter GDP growth was an unsustainable 5.6%. Indeed, some believe the wobbly stock market in the last two months seems to be predicting a slowdown. And, the Federal Reserve has a long history of raising rates to squeeze inflation out of the economy by slowing growth . . . too much! They do have a difficult job, because there is a long time lag between a rate increase now AND the subsequent impact on the economy AND the time necessary to recognize the impact. Estimates range from 9-16 months. (In other words, your portfolio could already be in tatters by this time.)

Traditionally, the Fed starts lowering rates only five or six months after the last rate increase, suggesting they usually go too far, increasing the rate too many times. After seventeen consecutive increases in interest rates, the economy must be expected to weaken.

Finally, the Index of Leading Economic Indicators fell in both April and May.

So, are we going to have a real recession in the near future? No.
Are we going to have a growth recession in the near future? Yes.
Why does it matter? Because the stock market will over-react! It is considerably more volatile than the economy it reflects.

If you are a long-term investor, you can probably just ignore it. Even if it is a “real” recession, the contraction phase for the last nine cycles has only been eleven months. However, if you tend to lose sleep whenever your portfolio goes down, eleven months is a long time! Ask your financial advisor about taking more defensive positions. For example, buy more companies producing consumer staples, like food, toothpaste, or everyday items. He might also advise you to avoid more cyclical stocks, like transportation. But, do talk with him or her soon!

The lesson is – take a long-term view and don’t over-react. The stock market will do that for you !

Jim Flinchum is a Certified Financial Planner practitioner and a Certified Investment Management Analyst.