Understanding How Traders Determine Periods of Economic Growth and Recession - dummies

Understanding How Traders Determine Periods of Economic Growth and Recession

By Joe Duarte

How do you know which part of the business cycle the economy is in? Officially, you don’t usually find out until months after that part of the cycle has either started or ended. The National Bureau of Economic Research (NBER) officially declares the peaks and troughs. The NBER is responsible for formally announcing the ends of peaks and troughs and signaling when a recession (end of a peak) or expansion (end of a trough) starts. You can see a table explaining the peaks and troughs since 1857.

The NBER identified December 2007 as the peak of the most recent economic expansion, but it didn’t make that pronouncement until December 2008. By the time the peak was declared, the market had been in a downtrend for 15 months, including the sharp selloff in September 2008.

The trough of June 2009 was not pronounced until September 2010, and currently, we’re still waiting for the next peak as the United States climbs out of its worst recession since World War II. The NBER determined that the recession lasted 18 months. Previously, the longest postwar recessions were those of 1973 to 1975 and 1981 to 1982, both of which were 16 months long.

As you can see, the time lag between events and when the NBER makes its announcements can be lengthy. But it can get worse. For example, the NBER declared on November 26, 2001, that the peak of the last business cycle was reached March 21, 2001. That was eight months later. The end of the trough for this cycle, November 2001, wasn’t announced until July 17, 2003. In other words, the economy was in a period of expansion/recovery for 20 months before the NBER made it official.

Unfortunately for all concerned, information that the NBER needs to make its official announcements isn’t always immediately available. The process of collecting economic data and revised preliminary estimates of economic activity takes time. Estimates and data don’t become available immediately after a particular part of any business cycle ends. As a result, before drawing any conclusions, the NBER must wait until it sees a clear picture of what’s happening with the economy.

Although many economists identify recessions and expansions based on at least two quarters (six months) of economic data, NBER uses its own models. Still, a growth spurt that lasts one full quarter doesn’t indicate the start of an expansion, nor does a decline that lasts a quarter indicate the start of a recession. Bearing that in mind, a time lag of at least six months is typically required before the NBER even considers declaring a recession or a recovery, which effectively renders the official announcement useless for traders.

The peak of a business cycle occurs during the last month before some key economic indicators begin to fall. These indicators include employment, output, and new housing starts. However, because neither a recession nor a recovery can be declared until enough data is accumulated, finding a way around the time lag of official information is impossible.

Signals that the economy was weakening became clear to the markets as early as summer 2007, when the major indexes hit their peaks. Looking at an earlier business cycle, you can see the whole process. Just as in 2007, clear signs that the economy was headed toward a recession were seen as early as the spring of 2000, which is when the NASDAQ index hit its peak and began its downward spiral.

The effects of the recession took a bit longer to hit the other major exchanges, but they started a downward trend by the summer of 2000. Just like in 2008, job losses had started mounting by mid‐2000, and many economists were already sending alarms that the economy was headed into a recession.

Even though the NBER announced the official beginning of that recession as March 21, 2001, and the official end of the trough and beginning of the recovery as November 2001, no significant recovery was seen in the markets until October 2002. Job growth remained anemic as of early 2004. The first sign of job growth was seen during the fourth quarter of 2003, after nearly three years of job losses. That economic expansion finally picked up steam and ultimately lasted through 2007.