“The Growth Hangover: Why Average Is OK” with faded stock charts in the background and “Weekly Viewpoint” in the top left corner.

The U.S. economy just closed the book on an epic quarter.

The strongest economic growth since the 1980s. The best S&P 500 earnings growth since 2009. A 20-year high in manufacturing activity. The list goes on.

But here’s the bad news: The second quarter could be as good as it gets for economic growth. After all, history shows it rarely gets much better. And now that the party’s likely over, the markets are nursing a bit of a hangover. The 10-year yield just fell for eight straight days, and stocks have stalled once again.

If you’re expecting slower growth ahead, you may be right. We could see a more normal-looking economy over the next several quarters. But contrary to what we’re seeing, a return to average growth – or a 2 to 3% annualized clip in gross domestic product (GDP) – isn’t something to stress about.

Graph titled Growth Tends to Peak Early in Economic Cycles shows quarter-over-quarter change in GDP from 1970 through 2020 with periods of recessions highlighted in 1970, 1974, 1980, 1982, 1990, 2001, 2008 and 2020. Peak GDP growth in cycle are called out in these quarters: Q1 1971, Q2 1978, Q1 1981, Q2 1983, Q2 2000, Q3 2003 and Q2 2014.

The Illusion of Validity

Investors are constantly on edge for the first sign of economic distress. It makes sense: The market is forward-looking, and finding the crack in the foundation could help you prepare for the next downturn.

And when you see a chart going down and to the right, it’s easy to dwell on the worst-case scenario. That’s the illusion of validity, when our brains overestimate the tendency for a pattern to continue despite other evidence.

But slowing growth doesn’t necessarily mean the economy is falling apart. In fact, it’s often a sign that the economy is just settling into a healthy new normal. It’s typical to see the economy bounce back quickly after a recession as spending and confidence comes back. As the cycle ages, that energy can wear off, and growth usually falls into a more normal pace.

Just look at the last seven economic cycles. These expansions lasted an average of 37 months beyond their strongest quarter of GDP growth. Only two of them reached peak GDP growth in their last year (and one of these cycles was only 12 months long).

Average Growth Has Fueled Long Cycles and Historic Rallies

Economic Cycle Years From Beginning of Cycle to Peak GDP Growth Years From Peak GDP Growth to End of Cycle Average Quarterly Change in GDP During Cycle S&P 500's Average Annual Return From Peak GDP Until End of Cycle
Nov 1970 – Nov 1973 0.4 2.6 3.8% 2.8%
Mar 1975 – Jan 1980 3.3 1.5 4.5% 8.4%
Jul 1980 – Jul 1981 0.7 0.3 3.2% -17.0%
Nov 1982 – Jul 1990 0.7 7.0 4.5% 11.4%
Mar 1991 – Mar 2001 9.3 0.7 3.8% -21.1%
Nov 2001 – Dec 2007 1.9 4.2 2.9% 10.0%
Jun 2009 – Feb 2020 5.1 5.6 2.3% 9.3%

Source: Ally Invest, Standard & Poor’s, Bureau of Economic Analysis, National Bureau of Economic Research
 
That could be what’s happening here. Earnings growth may slow, but analysts still expect S&P profits to grow by double digits in the next two quarters. Also, economists surveyed by Bloomberg expect the economy to grow at an inflation-adjusted annual rate of 5% or more through the end of the year, followed by a year of above-average growth in 2022. That’s nothing to scoff at, especially with a Federal Reserve focused on keeping the economy afloat.

More importantly, it’s crucial not to lose faith in the market just because the economy’s strongest growth may be behind us. In the past two cycles, the S&P 500 averaged 9 to 10% returns per year even after each cycle’s strongest quarter of GDP growth. And in both of those cases, if you had pulled out of the market when GDP growth peaked, you would’ve missed more than half of the rally.

The Goldilocks Effect

Average isn’t a bad thing for markets. In some cases, it can even be ideal.

Remember Goldilocks, the fairy-tale girl who broke into a house of bears and enjoyed a bed that felt just right? Sometimes the economy operates best in a “just right” environment: growth that isn’t too hot or too cold. In fact, in the last economic cycle, GDP grew just 2.3% per quarter on average – the lowest growth of any cycle going back to 1970 – even as the S&P quadrupled over 11 years of gains.

Plus, out-of-control growth can lead to dangerous trends like runaway inflation and overconfidence. Both of those have led to recessions in the past, like what we saw around the dot-com bubble. And there are still signs these days that growth could be a little too hot. Inflation is rising at its fastest pace in decades, and there are obvious signs of excessive optimism in the stock market. A little less momentum could keep the excess at bay, and that’s good for the economy.

There’s also room for improvement in this post-COVID economy. While some indicators may have peaked, others (think the job market and consumer confidence) could have a way to go. Put it all together, and the slack we’re seeing could signal that this cycle is still in its early stages.

The Bottom Line

It feels strange to celebrate average in a world that glorifies overachievers. But average growth has fueled some historic stock rallies. And if you base your investment decisions on cycle peaks, you may miss out on years of healthy returns.

Of course, with change comes new opportunity. We may already be seeing a rotation out of value stocks, which have led for most of this year on the anticipation for a post-COVID growth blowout, and into growth stocks. Right now, it could be worth looking for unloved stocks with earnings growth higher than the market average (the “growth at a reasonable price” strategy).

The path forward could be rocky, too. The S&P 500 hasn’t gone through a significant pullback in eight months, and worries of slowing growth could force investors into conservative investments like bonds, defensive stocks and precious metals. Safety hasn’t exactly been the market’s rallying cry lately, but it could come back in style.

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Headshot of Callie CoxAs senior investment strategist for Ally Invest, Callie Cox helps educate Ally Invest customers about the financial markets through engaging content and strategic initiatives. Callie has worked in financial research for her entire career, with stints at LPL Research, TABB Group and Bloomberg. Her work has been featured in Bloomberg, the Financial Times, Yahoo Finance, and Barron’s (among other publications). You can also find her on Twitter at @callieabost.


The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.