Don't Waste Time Predicting the Next Recession

October's market activity has many investors wondering if the next recession is just around the corner. Stirring up memories of the Great Recession and painful market crash of 10 years ago, warning stories are being voraciously consumed.

The current preoccupation about a recession is largely based on the fact that the current economic expansion and the accompanying bull market are both long-running. So, as the reasoning goes, both are long in the tooth and must end soon.

But a careful review of the evidence shows that the onset of the next recession cannot be predicted by how long the current expansion has lasted. In other words, even though we refer to them as business cycles, there is no regularity to the length of either half of the "cycle." Expansions do not come with an expiration date.

Putting Recessions in Perspective

If we look back at the recessions since World War II, we note that they have become less frequent and less severe, with the exception of 2008, which I will address shortly. In general, government officials are doing a better job of running monetary and fiscal policy, helped along by strong economic growth worldwide.

Increasingly, periods of economic growth are exceeding the length of recessions. To put this in perspective, the ratio of expansion years to recession years has increased 50% from 4 to 1 during the late 1940s and the '50s to 6 to 1 over the last 60 years.

The chart below highlights the incredible sustained stock market appreciation of the postwar boom and the Post-'70' era in spite of recurring recessions. The 17- and 22-year periods of market appreciation in this chart were each punctuated by three economic recessions, none of which derailed the long-term rise in the market. In this context, the current upward trending market may just be getting started.

S&P 500 PRICE INDEX (Log Scale, 12/31/1935 – 9/30/2018). Source: S&P Dow Jones Indices LLC

While somewhat oversimplified, protracted wars, severe external shocks and disastrous policy decisions seem to be the major detractors from steady long-term growth and even those are handled with time. These events are largely unpredictable in advance.

The Next Recession

Let me be very clear here: There will be another recession sometime in the future. The problem is we do not have any idea when that will be and what will be its cause. Will this October selloff trigger the next one? Highly unlikely.

What will trigger the next recession no one knows. Since 1980, the most common recession starter has been a government policy or Federal Reserve mistake. The worst Fed mistake was made by then-Chairman Ben Bernanke in September 2008 when he allowed Lehman Brothers to go under, shutting down the payment system upon which every U.S. financial transaction depends. Consequently, the Fed was transformed from the lender of last resort, the task at which Bernanke so miserably failed, into the lender to everyone. Thus, the huge Fed balance sheet looming over us to this day.

The saddest part of this story is that we were probably not in recession prior to Bernanke's terrible mistake. The traditional indicator is a two-quarter drop in real GDP, which was not the case prior to September 2008. The ever-reliable Purchasing Managers Indexes, to be discussed shortly, were not signaling recession either. I am puzzled why the National Bureau of Economic Research, the official arbiter of business cycles, pegged the recession start as December 2007 rather than as September 2008, the month in which both GDP and PMI clearly flashed recession.

We might have gone into a recession even if Bernanke had not made his fateful decision. Would it have been a mild one like we experienced in 1990 as a result of the savings and loan crisis, which had parallels to the subprime mortgage crisis leading up to 2008? We will never know.

Conventional wisdom has Bernanke the savior, pulling the economy back from the brink by means of the Fed's historic lending spree. Rather, he should be thought of as the guy who spreads nails on the highway and then offers to fix your flat tire a few miles down the road.

Following Economic Events

As a portfolio manager with a prior academic career, I am an economics and statistics geek through and through. You can imagine my disappointment early on when I discovered that current economic events have no consistent impact on market returns. In fact, research shows that market returns are predictive of economic events 6 to 9 months in the future. Thus, if you are following current economic events to make better investment decisions, you are largely wasting your time.

I follow the economy closely for enjoyment and for what it can tell me about long-term economic growth, which is important for long-term market returns. Following current economic events, however, I consider to be most often irrelevant when making investment decisions.

The indicators I do follow closely are the Institute of Supply Management PMIs — the manufacturing and non-manufacturing indexes. These have proven to be the most reliable indications of the current state of the economy. Having followed them for 40 years, I have yet to see a false signal. At present, both PMIs are among the highest ever. This says the economy is currently strong, but again says nothing about its future direction. Knowing where our immense economy is today is the best we can do.

Can the Expansion Continue?

The answer is yes. Unless there is a major government policy mistake or a Fed mistake, hopefully not as disastrous as Bernanke's 2008 fiasco, or some other yet unknown trigger, this expansion can continue. The economy grew 4.2% in the second quarter, its fastest pace in four years, and economic fundamentals are strong. The current environment, with its strong economy and low inflation, does not signal an imbalance that could end the expansion.

Since it is not possible to predict the next downturn, quit wasting time and energy on the futile effort of forecasting a future recession. As the saying goes, life is what happens to you while you are busy making other plans. Strong markets are what happen while you are worrying about the next recession.

— Check out When Does Stock Picking Work? on ThinkAdvisor.

Thomas Howard, Ph.D., is the CEO and chief investment officer at AthenaInvest and a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver. He can be reached at [email protected].