Weekly Wrap: Buying The Next Dip Might Not Be The Best Strategy

With the major portion of earnings season behind us, this week we are going to take a look at the vector and velocity of economic forces that will affect earnings in the coming quarters, but we first need to know where we are, before we can understand where we are likely to be heading. Much as they were for 1Q 2018, expectations for year over year earnings growth in the coming quarters is running rather high, but we are hearing more and more about rising costs and other inflationary pressures that could lead investors to revisit their profitability assumptions in the coming weeks and months.

In a typical business cycle, after a recession, the economy is saddled with excess capacity. Prices face serious downward pressure as supply is in excess of shrinking demand with households and corporations shifting away from consumption and expansion – most of the economy downshifts into survival mode. Capital expenditures are cut way back and remains loose.

Midway through the cycle, the Fed shifts towards less accommodative monetary policy as the output gap closes with spare capacity shrinking and prices are no longer falling. Late in the cycle, there is typically no excess capacity with cost and price pressures rising. The hikes rates, which either flattens or inverts the yield curve, creating debt service strains. Typically, the greatest pain is felt in those areas that benefited most from the prior excesses in credit.

As we discussed on this week's Cocktail Investing Podcast, at 107 months, we are now in the second longest economic expansion period in history, bested only by the dotcom boom-bust which lasted 120 months. For perspective, the average post-WWII expansion has lasted less than 60 months. This has also been the weakest growth period in U.S. history, averaging 2.1% GDP growth versus the prior eight expansion periods which averaged nearly twice that rate at 4.04%.

While this the second longest expansion in history, as the saying goes, no expansion ever died of old age. They die thanks to rate hikes and hello there, we are in a rate hike cycle with the most hawkish FOMC in years.

The real federal funds rate, (effective federal funds rate less core Personal Consumption Expenditure) has rarely ever been this low and we have never had the rate this low at this point in the economic cycle. This means that if the economy were to slide into a recession in the coming months, the Federal Reserve wouldn't have nearly as much room for stimulus as is typical using its primary monetary policy tool, the funds rate. Remember that when considering why the Federal Reserve may be seeing less-than-robust economic data, something we at Tematica have been talking about for some time.

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