Has This Cycle Reached Its Tail?

We asked a few friends what the picture below looks like, and most told us they saw a badly drawn bird with a wide open beak. Based on the photograph below our colorful bird, they might be on to something. 

As you might suspect, this article is not about our ability to graph a bird using Excel. The graph represents the current bull market and economic cycle as told by the yield curve and investor sentiment.

As the picture is almost complete, the bird provides a clue to where we are in the current cycle and when the next cycle may begin. For investors, one of the most important pieces of information is understanding where we are in the economic cycle as it offers a critical gauge in risk-taking.

Cycles

Economic Cycles- Economic cycles are frequently depicted with a sine wave gyrating above and below a longer-term trend line. Throughout history, economic cycles include periods where economic growth exceeds its potential as well as the inevitable busts when slower than potential growth occurs.  Most often cycles track a trend line, oscillating above and below it, but spend little time at the trend other than passing through it.

Boom and bust periods occur because economic activity is governed by human behavior. In other words, our spending habits are erratic because we are subject to bouts of optimism and pessimism about the economy, our financial prospects and a host of other non-financial issues.

The graph below shows the sine wave-like quality of U.S. GDP growth, which has wavered above and below trend growth for decades. 

Data Courtesy: St. Louis Federal Reserve (FRED)

Stock Market Cycles- Stock markets also follow a pattern that is well correlated to economic cycles. Strong economic activity results in investor optimism. During these periods, investors tend to believe that rising economic growth and strong corporate profits are long-lasting. As such they are prone to extrapolate these shorter-term trends over longer periods. Investors temporarily forget that periods of above-average growth will inevitably be met with periods of below-average growth. During bust periods, these mistakes are corrected and often over-corrected.

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