Any introductory economics course will have at its heart theories surrounding the business / economic cycle. The basics of this theory is that economies go through cycles moving from periods of expansion into contraction and then back to expansion. The basic point of economic policy is to try to smooth out these cycles so that we do not have too strong growth leading to high price increases (inflation) or stong contraction leading to high levels of unemployment.
A lot of the talk in the media is whether we are moving towards or are already in one of those contractionary periods. The technical term is a recession and the technical definition of a recession is a continuous period of two quarters (6 months) of negative growth.
Unfortunately we can only be sure about whether we have had a recession after the fact. But even if we knew where we were on the economic cycle how does this flow through to the investment world?
A small article in today's Australian newspaper discusses an investor's perspective of the recession debate - "Future strategy easy in retrospect". The original article was written for the Wall Street Journal by David Gaffen.
In the article Gaffen points out that investors start discounting an economic recovery about halfway through a recession which prompts a rise in stocks that continues as the economy picks up steam. However two pieces ofthe puzzle are missing:
1. When has the recession started?
2. When is it going to end?
He suggests that many believe that a recession began in the US somewhere around the first quarter of this year. In the 16 periods of economic contraction in the US since 1919, the average length of the contraction has been 13 months. And the conclusion he makes is that the US recession is at or even past the halfway point. (To add some further perspective, the two worst recessions of recent times began in November 1973 and July 1981 and both ran for 16 months)
Based on this analysis , have markets already priced in the recession and shouldn't we be jumping in boots and all into equity markets?
Unfortunately, Gaffen goes on to point out that the recession this time might be worse than average and we may not make halfway for another few months yet.
Whichever way you lean on the recession, this discussion provides an interesting perspective and some hope that the worst of the declines at least might be behind us. We will never know until years down the track.