An Economics Lesson From 1945

Editor's note: As the year comes to a close, we want to share our top market insights from 2022. Over the next few days, we'll take a look back at some of our favorite essays from Altimetry founder Joel Litman and director of research Rob Spivey.

To kick things off, we've updated the first in a series of essays comparing today's economy to what happened right after World War II. This issue was first published on July 11... And so far, the scenario we laid out still tracks what's going on today.

You can also check out the rest of the story through 1946, 1947, 1948, and beyond.

'Recession' seems to be everyone's favorite word lately...

People can't stop talking about the downturn our country might be facing.

Inflation is high. We're currently in a bear market. And people are still feeling the lasting effects of the COVID-19 pandemic.

But does that mean we're definitely heading toward a recession?

Before we can answer that question, we must really understand the term "recession"...

According to the National Bureau of Economic Research, a recession is a "significant decline in economic activity spread across the economy for more than a few months."

That's a pretty loose definition.

So many factors play into a recession – like gross domestic product ("GDP"), consumer spending, employment, and household income, just to name a few. All these components could lead to a "significant decline in economic activity."

That adds a level of complexity to actually figuring out if we're in a recession or not. And it's why most people simply look to the traditional sign that a downturn is on the horizon – declining real GDP for two consecutive quarters.

We already saw that earlier this year...

Real GDP declined 1.6% in the first quarter of 2022. And thanks to our ongoing inflation woes, it fell another 0.6% in the second quarter... before climbing back up in the third quarter.

Since it takes so long for the official numbers to come in, it's impossible to know if a recession is happening until it's already too late.

In other words, when we learn the truth, we're already two quarters into a recession. Sounds pretty terrifying, right?

But for many people, it doesn't necessarily feel like a recession...

Without looking at GDP growth or the market, your day-to-day life might not have changed as much as you'd expect it to in a downturn.

That's because the economy is actually doing quite well...

Employment is strong. Consumer demand is healthy. We haven't seen widespread credit issues.

In short, we're only in a "recession" based on its narrow definition (assuming we're in one at all).

Nominal GDP totaled 6% in the first quarter. That's a GDP metric based on current market prices. It remains strong... up more than 7% in the second quarter and more than 8% in the third quarter.

And as we already mentioned, employment is healthy while the Federal Reserve raises interest rates.

We've seen a setup like this before...

History may not repeat itself, but it certainly "rhymes." We could be following a similar playbook to the 1945 recession.

In the 1940s, real U.S. GDP was negative because the government cut spending as World War II ended.

During the war, the U.S. produced beyond its maximum potential GDP. It was "all hands on deck" for a time, but the production was unsustainable.

Said another way, U.S. GDP had nowhere to go but down.

The cut in spending simply brought GDP back down to its maximum potential.

Even as soldiers flooded back into the U.S. and started hunting for jobs, unemployment was just 1.9%. Again, this played out during an official "recession."

In fact, the market kept on rallying throughout the 1945 recession. The market understood why GDP declined... and what was really happening.

Over the summer, 2022 looked a lot like 1945...

Back then, the country was emerging from World War II. Now, we're coming out of the COVID-19 pandemic.

Throughout the pandemic, the government threw the kitchen sink at the economy. Between the Main Street Lending Program, Paycheck Protection Program loans, and multiple waves of stimulus checks, the powers that be did everything they could to keep the economy humming.

But now, it has been more than a year since the stimulus ended. The year-over-year comparisons aren't looking as good – much like when the U.S. wound down production and things returned to normal after World War II.

We've already recorded two quarters of negative real GDP growth earlier this year. Despite that, the economy looks strong. Businesses are recovering. Employment figures are still encouraging.

Even during the 1945 recession, the market shrugged off the headline print. Instead, investors focused on fundamentals.

It took another year for the market to even blink at what was going on in the economy. By the time the Fed got involved in 1947 – like it has been doing aggressively in the second half of 2022 – the market had largely stabilized.

Said another way... after recovering from an inflation-induced drop, stocks traded mostly sideways for the next year.

That's what we can expect heading into 2023. This isn't the time to throw money at the wall and see what sticks. Still, there will be no shortage of opportunities... if you know where to look.

Regards,

Joel Litman
December 27, 2022

Editor's note: If you want to hear more about the U.S. economy in the 1940s and today, be sure to check out Altimetry Director of Research Rob Spivey's recent interview. Rob joined Chuck Jaffe on the Money Life podcast to discuss where he thinks the economy is headed... and what it means for your finances. You can listen to their full conversation right here. (Rob's interview starts at 36:07.)