“Your money is like a bar of soap. The more you handle it, the smaller it gets.” — Economist Eugene Fama
The Federal Reserve’s necessarily vigorous response to persistently high inflation has increased the likelihood of a recession in the next 12 months if it hasn’t already begun. For many investors, the instinctive response to an impending slowdown is to retreat into a protective posture until the storm passes. However, one of the repeated lessons of history is that investors are often their own worst enemy, and that attempts to avoid short-term discomfort more often than not result in long-term damage. Too often the adversary is not the economy but our own behavioral psychology.
It’s helpful to step back and consider what it means to be in a “recession.” Economies are cyclical in nature, with periods of expansion and full employment followed by contraction in output and job losses. Until the early 20th century, all cyclical depressions were called “depressions.” In the wake of the crash of the 1930s, the slightly more benign term “recession” has been widely adopted to describe negative cycles less virulent than the Great Depression, but there is no official technical distinction. In the United States, the National Bureau of Economic Research is responsible for determining the start and end dates of recessions based on several factors, including GDP, employment, payroll income, and consumer spending. A colloquial, though unofficial, marker of recession is two consecutive quarters of negative GDP growth, which occurred in the first and second quarters of 2022.
There is no defined set of quantitative metrics that identify recessions. In effect, the appointment committee “knows it when they see it.” It usually takes up to a year for the National Bureau of Economic Research to officially declare the beginning of a recession, sometimes after it has already ended. This is a lesson for investors about the near impossibility of accurately timing the market around recessions.
In 2021, Charles Schwab published a simple analysis of the potential value of market momentum using historical data for the 20 years from 2001 to 2020. Case A calculated the hypothetical return of investing $2,000 each year at the bottom of the stock market, in other words, perfect timing. Case B calculated the returns of sinking $2,000 into the market on the first day of each year. While the perfect timer earned an annualized return of 12.5%, the constant Eddie earned 11.6% per year, a difference of less than a percentage point. Obviously, there is almost zero chance of getting it right every time. More importantly, one would have to be alert almost 80% of the time to time the market. good luck
Active timers must not only accurately predict the top of the market, they must also recognize the bottom correctly every time at the exact moment of the worst investor pessimism. Numerous simulations show that missing just the 10 best market days over 30 years cut your total return in half versus staying fully invested. And remember that half of the biggest gain days for stocks occur during bear markets.
The futility of overtrading to avoid recessionary losses becomes more intuitive once it is recognized that markets do not coincide with recessions but lead them. Market prices serve as a discounting mechanism for participants’ expectations of fundamental drivers, including corporate profits. In most cases, the stock market peaks before a recession officially begins. If you’re waiting for confirmation, it’s too late. Meanwhile, in almost every recession, the market bottoms out long before the economy begins to recover, about 10 months before the average recession ends. Waiting for signs of recovery? You probably lost a third of your earnings.
The overwhelming preponderance of evidence supports staying invested through business cycles given the immense difficulty of accurately predicting turns. But there are active steps that can be taken to maximize the likelihood of success. Investment decisions should be informed by a coherent plan that addresses specific financial goals and risk assessments. Building a diversified portfolio across a wide range of established asset classes and actively minimizing fees and expenses remains the path to success. The spectacular collapse of crypto house of cards FTX is a reminder that endorsements from quarterbacks or supermodels are nothing like investment advice.
It is also important during episodes of market turbulence to periodically rebalance portfolio holdings to plan targets, seizing opportunities to add assets at disproportionate discounts and restore the appropriate risk profile. And the increased risk of an economic downturn suggests an excellent time to strengthen personal balance sheets by paying down high-interest debt and reducing controllable expenses to avoid uncertainty.
The US has experienced 14 recessions and 26 bear markets (losses of 20% or more) since 1929. During that same period, a passive exposure to the US stock market returned a cumulative 500,000% with reinvested dividends. There should be a lesson in that.
“We have met the enemy, and he is us.” — Walt Kelly (“Pogo”)
Chris Hopkins is a chartered financial analyst and founder of Apogee Wealth Advisors in Chattanooga.