Discerning cycles from trends is one of the most critical decisions investors must make. The financial dust bin is littered with unrealistic trendlines drawn by business leaders and investment managers. When crude peaked at $147/bbl in 2008, optimistic oil analysts were forecasting $400/bbl. Strategists celebrated the death of the business cycle only a few quarters before the economy was plagued by financial crisis in 2008. It is for these reasons why the world’s tallest buildings are built at economic peaks. Construction of the Empire State Building commenced in 1930, as the Great Depression began. Developers broke ground on the World Trade Center in 1966, three years before a series of recessions that enveloped five of the next 10 years; Sears Tower was built concurrently.
Right now, the US economy is firing on all cylinders: unemployment is low and economic growth is high. Economic effervescence prompted President Trump to crow that it was the first time in 100 years that economic growth has exceeded the unemployment rate. While it is indeed a rare occurrence, a similar crossover occurred 10 years ago. Meanwhile, earnings among S&P 500 companies rocketed more than 25% over the 12 months through Q2, thanks to a reduction in the corporate tax rate and a rollback in business regulations. Small companies are celebrating, too. The National Federation of Independent Businesses recently reported that small business optimism hit an all-time high, breaking a record set in 1983. Capital spending plans reached its highest level since 2007, according to the report.
Investors are lying awake at night pondering this question: Is today’s economic enthusiasm a peak, or is it a trend? Based on recent market returns, it seems to us that today’s environment resembles midnight on New Year’s Eve more than it does a tailgating party before the beginning of an undefeated season. Equity investors seem to agree, which is likely the main reason why the advance in blue chips has been less than half the growth seen in earnings. It might also be the reason why blue chips are holding up relatively well in response to Trump’s troubles, as investors increasingly believe the fiscal stimulus cards have already been played.
While we don’t believe the economy is on the precipice of recession, we increasingly sense that the growth rate is set to slow. We are on the lookout for a deterioration in credit conditions, a metric that has historically been a useful early warning indicator. For now, we remain committed to our positions but are standing by to reduce our risk exposure.