Key Takeaways

  • Equity prices have staged an extreme recovery amid a steep and sudden recession
  • Stocks bottom before some popular leading economic indicators bottom, historically
  • ECRI expects this recession to be short, but nasty

Against the backdrop of the deepest recession in living memory, there’s widespread bafflement about the rally in equities. It’s a seemingly clear case of cognitive dissonance. But there’s a perfectly rational explanation for the divergence. Bottom line, it makes perfect sense for stocks to have turned up in March.

It was already clear to us in early April that this nasty, short and bitter recession would be extremely deep, very broad in terms of diffusion, but relatively brief in duration. Recently, the National Bureau of Economic Research determined that the recession began in February 2020, echoing what we had determined more than two months earlier. It noted that "the unprecedented magnitude of the decline ... and its broad reach across the entire economy, warrants the designation of this episode as a recession, even if it turns out to be briefer than earlier contractions" (italics ours). 

The reason we had expected this brutal recession to be so short is that, after widespread forced shutdowns, as the economy started opening up, it would “begin reviving, albeit slowly and partially. As a result, the level of economic activity … will necessarily rise above the lows seen during the worst of the closures. By definition, when … economic activity starts to increase on a sustained basis – even slowly from a low base – the recession will have ended.” 

The Key to a Cyclical Recovery

But the real key to a cyclical recovery is the switch from a recessionary vicious cycle of falling output, employment, income and sales to a self-feeding virtuous cycle of rising output leading to job gains, resulting in rising incomes and sales, feeding back into a further increase in output. And while a recession can be forced upon the economy by ordering establishments to shut down and citizens to stay at home, a recovery cannot be forced by ordering businesses to open up and consumers to spend. You can’t mandate that virtuous cycle, and for all the focus on medical data and cell phone tracking, those metrics can’t foresee the timing of a cyclical recovery.

The way to know when a virtuous cycle is ready to take hold is to monitor good leading indexes that can foresee when this dynamic will be ready to gain traction. 

Since we discussed in early April why this recession would logically be quite short, ECRI’s leading indexes have provided objective support for our thesis that this will turn out to be an unusually short recession. Specifically, our Weekly Leading Index (WLI) has now risen for ten straight weeks from its March low, following a nine-week plunge.

Chart courtesy ECRI
Chart courtesy ECRI.

That upturn goes well beyond the equity market to leading indicators of the real economy. Most importantly, ECRI’s recovery call is based not just on this publicly-available index, but textbook sequential advances in the entire array of leading indexes we use for economic cycle forecasting.

Some might protest that other well-known leading indexes, like the Conference Board’s Index of Leading Economic Indicators (LEI), are still falling. And the OECD’s Composite Leading Index (CLI) – released in June – has only just shown its first uptick. That’s par for the course in terms of their real-time performance. 

Chart courtesy ECRI
Chart courtesy ECRI.

For example, right after ECRI predicted in April 2009 that the recession would end by that summer, the Conference Board said that there was “no reason to think” that it would, given that the LEI hadn’t risen since June 2008. And the OECD CLI’s real-time performance wasn’t much better: it wasn’t until its June 2009 release – five months after ECRI’s U.S. Long Leading Index first displayed a potential trough, and two months after the WLI had done so – that the CLI ticked up. 

That real-time history is important because the pattern seems to be repeating today. As Yogi Berra said, "it's like déjà vu all over again." 

Stock Prices Bottom Before Business Cycles

Certainly, the Fed’s highly accommodative monetary policy and backstopping of credit markets have helped to bolster securities prices. But if we’re right that the end of the recession is at hand, it makes perfect sense – in terms of cyclical timing – for stock prices to have turned up in late March, because stock price troughs always lead business cycle troughs, turning up before a recession has ended. This is the cyclical equivalent of buying when there’s blood in the water. Please recall that equities also bottomed in March 2009, when all the talk was of Depression, three months before the Great Recession ended in June 2009.

Chart courtesy ECRI
Chart courtesy ECRI.

The recovery from that recession was accompanied by a cyclical upturn in economic growth – a growth rate cycle (GRC) upturn – that continued apace well into 2010. So stock prices kept rising. 

But the recovery from the 2001 recession presents a very different scenario. During that episode, the recession ended in November 2001, and the S&P 500 turned up the week after the 9/11 attacks. But, after initially rallying over 20% through early January 2002, it turned down, plunging to a lower low by October 2002, far below the September low that anticipated the end of the 2001 recession. 

What happened was that a fresh slowdown in economic growth – a new GRC downturn – started in mid-2002. That prospect was enough to trigger a new stock price downturn. That it fell well below September 2001 levels had to do with the extreme overvaluation of equities in the dotcom boom that hadn’t been fully squeezed out earlier. 

2009-10, or 2001-02?

So, the key question today is, are we in for a 2009-10 scenario, when stock prices essentially kept rising? Or are we facing a 2001-02 scenario, where we’ll have a fresh GRC downturn, possibly brought on by an unexpectedly large spike in infections or a second wave of the pandemic that heightens fear or uncertainty, or a fresh round of job losses later this year? 

It’s too soon to tell, but this will be the question everyone wrestles with over the summer and into the fall. From our cyclical perspective, if such a fresh slowdown were to appear on the horizon after a recovery begins, as in 2002, our leading indexes will flag that promptly.

[ECRI co-founder, Anirvan Banerji contributed to this column.]