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 / Spring 2007 / Issue 46(originally published by Booz & Company)


Joseph Ellis: The Thought Leader Interview

We also have to address what I call the “recession obsession.” Strictly speaking, a recession is an absolute decline in gross domestic product [GDP] for at least two quarters. Economists and much of the business press focus on recession as the key measure of an economic downturn. But by the time we reach a recession, most of the slowdown in growth is pretty much behind us. The bear market occurs well before the recession, and the recession is therefore a relatively useless, lagging indicator of economic slowdown.

S+B: So when a recession starts, that’s actually a signal that things are going to improve?
It’s not quite that simple. The key is understanding the difference between growth and rates of growth. Let me explain.

Most commentators on the economic news tend to divide the economic cycle into two parts. They call the good part of the cycle “growth,” meaning absolute increases in real GDP, and they see the bad part of the cycle as “recession.” But by the time a cycle gets to the point where the economy is declining in absolute terms, the rate of growth in the economy may have been slowing for as long as two years. Most of the damage to businesses’ sales and corporate profits, and to the stock market, is already done.

When we look back over 40 years of economic cycles, we see that the economic damage in a cycle begins when the rate of growth peaks at, say, 6 percent, and then slows first to 4 percent year-to-year, and then to 2 percent year-to-year, and then to zero. (A chart on my Web site shows this in detail.) And here’s the grabber: In almost every cycle, the bear market also begins when the rate of economic growth peaks at 6 percent or 4 percent. That peak in the growth rate of the economy is the point at which corporate profit growth is the greatest, optimism is the strongest, and inventory creation is the highest. Business conditions and stock market performance turn downhill from there. By the time you get to the 2 percent growth rate, and before the recession begins, the crisis is usually nearing its end.

S+B: You’re explaining the old adage “buy low, sell high” through a kind of historical analysis.
Exactly. “Buy low, sell high” is a saying that is almost self-mocking in its own delusion, because most people buy high and sell low. The very reason that markets reach highs is that investors are extrapolating good conditions when growth rates are at their peak.

S+B: What, then, is the consistent leading indicator — the factor that’s “ahead of the curve,” as your book title puts it?
In the broadest sense, it’s real personal consumption expenditures, or PCE. In other words, consumer spending. For the 40-plus years of data that I tracked, consumer spending always preceded most other economic indicators by one or two quarters; it points the way, more than any other signal, toward whether economic life is about to get better or worse. Most economists recognize this, although a surprising number actually think business investment leads consumer spending, which it demonstrably does not.

Unraveling Spaghetti

S+B: What led you to begin tracking the data that way in the first place?
When I joined Goldman Sachs in the early 1970s as an analyst specializing in retail, I faced an issue common to most analysts: Where does my industry fit into the overall cycle of economic growth and decline? And, specifically, when would retailing outperform other industries, and when would it underperform?

Like all analysts — and all portfolio managers and businesspeople, for that matter — I had a flood of anecdotal economic data coming at me every month. But I (and others) couldn’t make sense of it. I wanted to develop my own, more systematic approach to getting a leg up on the process.

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