HE PAST FEW YEARS HAVEN'T BEEN too kind to investors. Stocks topped out in early 2000 and joined the overall economy in a downward slump. As the economy cooled, so did earnings, demand, and corporate profits.

But the trend reversed in the autumn of 2002 as both stocks and economic signals began to pick up. Indeed, many economists believe the economy bottomed six to nine months earlier at least partially explaining last fall's equity recovery.

Both the stock market and the nation's economy are known to be cyclical. If you pull out an introductory finance or economics text, you'll probably see some sort of chart that looks like a sine wave, with roughly equal highs and lows and a steady movement between the two.

Just as in the 2000-2001 period when the economy weakened, lower demand cuts corporate profits and share prices fall reflecting lowered prospects. By the time this economic contraction runs its course, corporations have cut production, run through excess inventory, and have reduced costs.

At that point the economy begins its next upward cycle as renewed demand leads to increased sales, profits, and rising share prices. Eventually this positive cycle tops out and the next contraction begins.

Trend Spotting

Of course stocks don't always lead the economy. That certainly didn't happen last year when economic signals began to turn up in the second quarter, a half-year before stocks responded. When stocks did come around, they staged a powerful recovery leading many to wonder if share prices had gotten ahead of the actual recovery.

Back in July we argued that it was time for the economy to flex its muscles in order to sustain the equity rally. Investors had bid share prices up expecting a stronger second half of 2003, and it was time for the economy to provide some long-awaited support.

While still sending mixed signals, the economy seems to be delivering. Third quarter profits surged, many exceeding the expectations of usually overly-optimistic analysts. Consumer spending continues to buoy demand, and GDP is mildly accelerating.

Employment is the only remaining fly in the ointment. Weekly jobless claims still hover around 400,000 and so far, few new positions are being created. Still, employment is a lagging indicator, only seeing improvement once recovery is well established. Should the economy continue to strengthen, employers will begin hiring and this statistic will also come around.

Which brings us back to the main question: Will the economy continue to improve and support further equity gains, or has it already begun to top out after only a minor recovery?

Historically, recoveries have lasted longer than contractions with the entire market cycle lasting 5-7 years. That's resulted in about one recession per decade. Based solely on this, you could conclude we're only at the beginning of this decade's expansion.

But averages don't necessarily show how things will play out this time, only how they usually do. If the consensus is correct, the current recovery is already into its seventh quarter. Granted, it's been fairly muted, but then so was the recession leading up to it. The old sine wave with equal distances between cyclical tops and bottoms leaves a little to be desired in the real economy.

That's actually the crux of the problem: Despite the abundance (some would argue overabundance) of economic data, it's still difficult to fathom just where we are in the economic cycle. Each month, the government regularly releases a vast array of statistics, but so much of it fluctuates from period to period and much of it is just noise.

Short-Term Noise, Long-Term Cycle

Data Source: Baseline It's hard to get a fix on the current point in the economic cycle, especially when periodic data vary so dramatically from point to point. Nevertheless, a longer-term perspective -- in this case a six-period trendline -- can be more informative. The "economic cycle" is clearly visible although it's not the perfect sine wave of introductory economics textbooks.

Consider the quarterly GDP data represented by the green line on the chart above. See any trends there? It's supposed to be adjusted for seasonal fluctuations, but it's still all over the board.

However, if you adopt a longer-term perspective, the cycle emerges. The red line on the chart above represents a six-period trendline. It looks a lot more like your textbook economic cycle although it's not nearly as symmetrical. Such is the price of reality.

This trendline can actually be pretty informative. First notice that it indicates the economy most recently topped out in the third quarter of 1997, just when stocks were taking off. So much for the predictive power of equities.

It also suggests the recession came to an end as economists believe, around the first quarter of 2002. Stocks still had six more months to decline. Another black eye for prophetic investors.

It's encouraging to see the trend turning sharply up at the end of the graph. This suggests not only is a recovery underway, it's a powerful one. After bidding forward P/Es up to around 20x on the S&P 500, investors are betting on this as well.

But before running to bet the farm on stocks, the trendline can be read as suggesting caution, too. Notice that the distance between its peaks and valleys is shrinking. Back in the 1990s, many economists commended on this "smoothing" of the market cycle. They saw it as a positive, arguing that a deep recession did not necessarily have to follow a decade of expansion. Now it might also indicate that the current brief expansion may already be nearing its cyclical peak.

We'd recommend not reading too much at all into the trendline. It has a relatively low r² of only .2297. If you're not statistically inclined (and what normal person is?) all this means is that the trendline only has a very mild relation with the quarterly data it's thought to represent. You should think twice about drawing any conclusions based on this alone.

Real Signs

Sustained recoveries usually take place when inflation is under control, interest rates are stable and monetary and fiscal conditions are favorable for equities. When these conditions begin to deteriorate -- often when the economy starts to overheat -- the cycle begins to turn back down.

News -- or lack of it -- on the inflation front is encouraging. The Fed remains more concerned about it falling too far than climbing excessively. Indeed, both the Consumer Price Index and the Producer Price Index seem well on course to finish the year 1-2% below their historical averages.

Low inflation at the wholesale level is good for businesses since it keeps a lid on the raw materials needed for production. But low retail inflation actually has a negative impact on corporate earnings since it drastically limits firms' pricing power. When overall prices aren't rising, companies can't increase revenues by increasing their prices. Profits can only be increased by selling more product or through cost cutting, and only the former is a basis for sustainable growth.

Steady State

Source: Baseline In response to fluctuating economic indicators, yields have been both up and down. Still, looking back over the past twelve months, the yield curve has been relatively unchanged.

The mild inflationary environment has enabled the Fed to keep interest rates near historical lows. With the Federal Funds rate at 1%, the Fed is being about as accommodative as possible.  In addition, this stance could last for -- in the Fed's words -- "a considerable period of time".

Of course bond investors who are always fearful that something good will happen in the economy are already busy speculating on when the Fed will begin ratcheting up rates. Despite this summer's turbulence, yields have remained relatively stable, especially if you take a little longer-term view and consider where they've been in the past twelve months.

We've argued before that even after the late summer's jump, yields are still near historical lows. Even more importantly, it's not the absolute interest level that's important but rather the fact that rates are stable and not trending higher. That doesn't seem to be the case now -- at least yet.

Falling Spreads

Data Source: Baseline As stocks were approaching their bottom in October 2002, traders were fleeing to the safety of Treasuries. But ever since then, bond investors have been willing to take on more risk by swapping out of Treasuries and into comparable corporate bonds. The increased demand for corporates has driven their yields down while Treasury yields have drifted up, narrowing the spread between the two.

Low and stable interest rates create a favorable environment for equities, too. With the cost of borrowing down, businesses can afford to take on new projects, buy new equipment, and ultimately hire more employees to run the new projects and equipment. With rates holding steady, firms can confidently take on new expenditures. This translates into a positive for equities as increased capacity and efficiency adds to the bottom line.

Bond investors have already taking on more risk. This is evident from the declining Corporate Bond Spread which measures the difference between corporate yields and those of Treasuries with the same maturities.

As illustrated by the nearby chart, the Corporate Yield Spread has decreased considerably since mid-October 2002. This indicates that bond investors are willing to swap out of the relative safety of Treasuries and into corporate bonds with higher yields. As more an more investors do this, Treasury yields begin to rise and corporate yields decline, closing the gap.

Best Guess Scenario

Historically the Corporate Yield Spread and GDP have been inversely related. According to Baseline data, over the past twenty years the correlation coefficient has hovered around -0.4. The highest relation occurs when the Corporate Yield Spread is lagged by two months. This is shown on the chart below.

Essentially this means that historically, when the spread between corporate and Treasury bonds was narrowing, GDP was growing at a higher rate than when the spread was widening. Although the spread is a better lagging than leading indicator, its current trend still suggests the expansion may still have some life left.

How much life? That it doesn't tell you. In fact there isn't one, single indicator you can point to that does. Nevertheless, here's our best estimate (guess?) of what's ahead in the remainer of this year and into 2004:

Spread the Growth

Source: Baseline Historically, the Corporate Yield Spread and GDP growth have been negatively related, when one goes up, the other goes down. Over the past year GDP growth has been improving while the yield spread was falling. Although best used as a lagging indicator, changes in the yield spread may offer some insight into the short-term path of the economy.

We do expect the expansion to continue, it has after all, been only one year in the making. Demand, while strengthening, is still rather tepid and should continue to rise. By the same token, consumer spending never really dried up as in past recessions, so this recovery will have to succeed without the push of pent-up demand.

Perhaps the best indication that the recovery can continue is a resumption in capital spending by businesses. There's already a little evidence that this is picking up and should corporate investment continue to grow, the economy can forge ahead.

Corporations have done a good job cutting costs, so as demand picks up, top line gains will quickly become bottom line profits. This is especially true for small cap companies that went into the slowdown with little if any debt. Recognizing this, investors spent 2003 bidding up small cap stocks.

It wouldn't be surprising to see interest pick up for large caps as the year comes to a close. Not only is their valuation now more appealing relative to small caps, many money managers will also seek their name recognition and perceived safety for year-end window dressing.

Barring any major disappointments or negative developments, the equity rally should continue into 2004. Earnings comparisons will be relatively easy and economic growth -- although not spectacular -- can continue.

Perhaps the best way to get a sense of what's in store for stocks is to look back at results from previous recoveries. The current bull market began in October 2002, so has already run one year. The question, therefore, is what can be expected in the second year?

According to Standard and Poor's data going back to 1971, in the first year of a bull market, the S&P 500 has averaged a gain of 38%, and the Nasdaq 54%. This is remarkably close to the 34% and 58% logged by the S&P 500 and Nasdaq, respectively, over the past year through October 9th.

Based on the same data, in the second year of a bull market, the S&P has historically gained 14%, the Nasdaq 9%, and small cap stocks 4%. While not spectacular, this fits well with our expectation that profits will continue to grow at a moderate pace and that traders will shift from riskier small cap stocks into large caps.

The economy and financial markets do move in cycles, but the exact paths are never the same. Historical averages can never tell you precisely what will happen this time, but they are often the best guidepost. There's no reason to suspect it's any different now.

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