Will There Be A Recession?

There has been a lot of talk recently about a recession, with concerns about slowing economic growth, the Federal Reserve cutting interest rates, an inverted yield curve, a trade war with China, and so on. A recession is two or more quarters of economic contraction, of negative growth of a country’s economy. Several European countries recently reported one quarter of negative growth and may well be on their way towards a recession this quarter. 

So… will there be a recession in the US? Yes, there will. When? I have no idea.

Please excuse my glib answer. I could put a lot of thought and analysis into the question, but statistically, it’s not predictable with accuracy or certainty. Recessions are an inevitable part of the economic cycle, winter to the summer season of expansion. Unfortunately, unlike December 22, the first day of winter, it is not possible to determine when the first day of a recession will occur. Economists only calculate recessions in hindsight and it would be foolish, and likely even detrimental, for investors to try to change their investments based on today’s recession fears. 

While the US Stock Market made new highs in July, August saw a pullback with increasing worries about a recession. A recession would be negative for investors in the short run, but I think it is very important for investors to stay focused on the long run. The temptation is to think that if we could go to cash before a recession that our returns would be better and we’d avoid losses. As appealing and rational as those thoughts may be, the reality is that attempting to time the market is exceedingly difficult. In my experience, investors who try to time the market rarely do better than those who remain invested and they often would have been better off making no changes.  

Thankfully, I don’t think you need a crystal ball to be a successful investor. Let’s keep a healthy perspective on recessions. Here are some thoughts which may help you to stay invested.

1. If you’re a young investor, contributing monthly to your 401(k) or IRA, and have three or four decades before you retire, you should want a recession! That’s the stock market throwing you a fire sale. You get to buy shares when they are down maybe 20% or more! While Dollar Cost Averaging cannot guarantee a profit, I can tell you that the shares of mutual funds which your colleagues bought in 2008 or 2001 have probably been enormously profitable. If you bought an S&P 500 Index fund 10 years ago, you’d be up about 320% today. 

Recessions have occurred every 5-10 years since 1900. If you are investing for many decades, I wouldn’t be worried about what happens in 2019 or 2020. If the market goes down, keep buying shares of a diversified asset allocation and be glad to buy shares with a very low cost basis.  

Do, however, avoid betting heavily on an individual stock. While the overall stock market has recovered very nicely from previous recessions, there can always be individual companies like Lehman Brothers or Enron, which don’t survive. Those companies may be present in an Index Fund, but if your fund owns 500 or 1000 companies, the impact of one company blowing up is often inconsequential.

2. Think in percentages, not dollars, and study stock market history. A 20%+ drop in the market does occur from time to time, maybe even two or more times a decade. Knowing this, you should be prepared for a drop of this magnitude if you’re in an aggressive allocation. But let’s rephrase this in dollar terms: once you have a $500,000 portfolio, could you stomach a drop of $100,000? That sounds a lot worse than a 20% drop! Of course, when the market goes up 20%, like it did from December 2018 to the highs of July, that would also be a $100,000 gain. 

Seeing performance in dollar terms may feel harsher than looking at performance as percentages which fluctuate greatly from year to year. When you have a big account, you are going to see big swings. This can be difficult to get used to and that’s why I want to look at percentages instead.

If you understand that a market cycle includes up and down years, you will understand that a drop is often only temporary until the market rebounds. If you sell when the market is down and go to cash, you are locking in that loss and eliminating the possibility of participating in a future up cycle. While there’s no guarantee this cycle will always occur in the future, it has been the historical pattern, and I think you have to embrace this tenet of investing if you are to be successful over time. 

3. We build highly diversified portfolios and rebalance. If your target allocation is 60% stocks and 40% bonds (60/40) and the market drops, your weighting to stocks decreases. We will sell some bonds and buy stocks that are down. We have a built-in mechanism to respond to market fluctuations already. Just by maintaining a target allocation and rebalancing, we will be buying stocks when they are on sale and trimming stocks when they have run up. That won’t prevent a loss when the market does drop, but rebalancing can help to potentially smooth returns and maintain your target level of risk for your portfolio.

4. Investors who are getting closer to retirement undoubtedly feel the most pressure about near-term performance. In part, this is due to an oversimplification of the retirement planning process, by using something like the “4% rule”. Then, if your portfolio drops 20% in the year before retirement, it would appear to be devastating. If you were expecting $40,000 a year in income from a $1 million portfolio, a drop to $800,000 would reduce your 4% withdrawal rate to just $32,000 a year. 

That’s why we should be careful about using a “rule of thumb” approach as being the ultimate guide in retirement planning. For someone who is 65 and healthy, we should be planning for a 20-30 year time horizon, not for the next 1-2 years. As retirements become longer, it is a reality that you are going to experience multiple recessions. Looking at a retirement date of 1-3 years away does not mean that you automatically have a short-term investment horizon. We need to think long-term and have a plan that isn’t going to be derailed by performance in the last year or two before retirement. 

5. If you’re retired and taking 4% withdrawals, consider this: The dividends in our US stock market ETFs are around 2% and higher for our foreign ETFs, often in the 3% range. Even with today’s low interest rates, your bonds are overall yielding 2% or more. Regardless of your allocation, you’ve already covered at least half of your annual 4% withdrawals from stock dividends and bond interest. In terms of sales, you might be dipping into principal by only 2% a year or less. If the market is down for a year or two, you’re not going to run out of money. For my clients who are taking distributions, we set dividends and interest to pay out in cash and I generally only have to sell a small number of shares once a year.

I’m not looking forward to a recession or a Bear Market, but I’m not really all that worried either. Knowing that recessions are a natural part of the economic cycle doesn’t make them any less painful, but if you can step back and take a longer-term view, you will be more comfortable with accepting that being an investor requires patience, perseverance, and a positive attitude.  We’ve built our portfolios for all environments, but that doesn’t mean that risk can be avoided or eliminated. Rather, we can choose how much risk we take and to avoid unnecessary risks of being overweight one stock, sector/country funds, or being undiversified. Whether you are a new investor or a retiree, I don’t want you to make knee-jerk reactions because of talk about a future recession. Recession talk may play well on cable news, but it’s not a useful input for long-term investment success. 

Storm Clouds Gathering

Being an investor requires the humility to acknowledge that no one has a crystal ball and we cannot control the future. I find it best to ignore predictions and forecasts and to tune out day to day news, especially from “experts”. It’s just noise that distracts us from our process. There are always Bulls and Bears, so we run the risk of Confirmation Bias, embracing evidence that conforms to our beliefs and disregarding arguments that differ.

The current Bull Market is nine years old and there have been ample reasons for several years to think that we are in the late innings of this expansion. But anyone who has tried to time the market over the past decade has almost certainly hurt their returns rather than enhanced them.
Over the past two weeks, we’ve observed two significant economic signals which like the proverbial “canary in the coal mine” have been strong predictors of past Bear Markets. Because of their rarity and historical significance, I think investors should consider these signals with more weight than opinions, forecasts, or projections.

1. The crossover of the Equity Circuit Breaker. We’ve described this technical analysis previously, but here is a quick review: We look at the S&P 500 Index and calculate Moving Averages based on the previous closing prices of the past 60 and 120 days. That is each day, we look back at the previous 60 and 120 days. When the market is in an uptrend, the 60 day moving average stays above the 120 day average and both lines are sloping upwards. 

In a Bear Market, a prolonged downturn, the 60 day moving average is below the 120 day average and both are sloping down. The signal occurs when these two lines crossover; this reflects a potential change in regime from an up market to a down market. Because we are looking at longer averages – 60 and 120 days – this analysis usually tunes out brief market panics of a month or two. A crossover occurred this year at the end of November.  

This crossover was a good predictor in past Bear Markets; it would have gotten you out of stocks very early in the 2008 crash and back into stocks in the Fall of 2009. However, it can give false positives. Back in 2016, we also had a crossover occur for several months. That year, if you had traded on the crossovers, you would have gotten out at a loss and then had to buy back into stocks several percentage points higher.

2. Yield Curve Inversion. Typically, longer-dated bonds pay higher interest rates than shorter bonds. This week, however, we briefly saw the five-year Treasury Bond trade at a lower yield than the two-year Treasury, an inversion of the normal upwards slope of the yield curve. 

Why should you care? A Yield Curve Inversion has been a good predictor of previous recessions. This shows that investors are bidding up five-year bonds, preferring to tie up their money for longer, seeing a lack of short-term opportunities elsewhere. It also reflects a belief that interest rates may fall.

Past Yield Curve Inversions have occurred in 1978, 1988, 1998, 2000, 2005-2006. In each case, except for 1998, a recession took place within a year or two. So it does not have a 100% track record of accuracy either, but it is a rare enough of an event that I think it is worth our very careful consideration. The seven previous recessions all were preceded by a yield curve inversion.

Read More: from Bloomberg, “The US Yield Curve Just Inverted. That’s Huge.”

Over the past several years, when people asked me what it would take for me to become concerned about a Bear Market, I would have told them these two things: a crossover of the moving averages and a yield curve inversion. Both have been good (but not perfect) predictors of past Bear Markets and Recessions. And both have occurred since Thanksgiving this year.

The market may continue to go up in 2019, so I cannot assume anything with certainty. Still, I am concerned enough about these two signals that we are going to be slightly reducing our equity exposure and risk levels for our 2019 models. This is a temporary, tactical move and we will look to move back to our target equity weighting either when we feel that prices are significantly distressed, or after the moving averages have crossed back upwards. We are not going 100% to cash; at this point, we are considering reducing equities by 20%, pending further analysis this week.

We will be making necessary trades on a household by household basis before January 1, making sure we minimize any possible tax liabilities. We will look to harvest losses in taxable accounts and to try to avoid creating gains except in IRAs. 

While there’s no guarantee these trades will be profitable, I take these two signals seriously enough that I feel compelled to act and will be doing the same trades in my own portfolio. If we do have a prolonged Bear Market, we may wish to have sold even more. However, I want to balance that risk with the fact that these signals could be wrong this time. Perhaps the market continues up for another year or two before there is a recession and we miss out on significant further gains.  

Investors were not at all successful at timing the market back in 2007-2009, even though with the gift of hindsight, we might think it will be “easy” to see and act next time around. My goal remains to create effective, diversified portfolios that are logical, low cost, and tax-efficient. Making tactical adjustments to reduce risk and hopefully enhance returns is what clients expect from me, but we do not make these changes lightly. If you have questions about your portfolio, or want to talk in more detail about these signals, or the economy, I am always happy to have a conversation about what we can do for you.