Over the last fifty years, there have been seven recessions. Each was different. In some, the drop in economic activity, as measured by the Gross Domestic Product (GDP), was small. For example, during the 1969 to 1970 recession, GDP shrank by only 0.2%, and from 2000 to 2002 it decreased by 0.4%. In others, the decrease was more severe: the prolonged mid-‘70s recession saw GDP drop 3.1% and in the last recession, our economy fell 4%.
Recessions are a natural part of the economic cycle. Presidents and Federal Reserve Chairs cannot eliminate them. They are a product of human behavior: economic growth leads to investor optimism, which pushes equity markets to appreciate faster than what corporate profits can sustain. When uncertainty emerges, there is a reduction in business investment and consumer spending. This cycle occurs on average every seven years.
Recessions impact workers, business owners, and investors in different ways. Employers may have to cut jobs. A company may find it no longer can meet its obligations and be forced to declare bankruptcy. For investors, less business activity leads to lower profits and lower stock valuations. It is important to appreciate that while stock market drops are usually more significant than the actual reduction in economic activity, the fall often comes after a period of excess returns. For example, in the five years leading up to the 1990 recession, the U.S. stock market, as measured by the S&P500 Index, more than doubled, then dropped by 20% from July of 1990 to October of that year. The drop reduced the 17% annualized return during the five preceding years to 12%. In the five years preceding the recession of 2001, the S&P500 Index more than tripled and then dropped by half. The drop brought the five-year return from 26% down to 10%, a more reasonable long-term return but still above average.
Given the reality that there will be a recession in our future, there is a natural tendency to want to adjust our investment strategy in advance of a market drop. Ideally we would like to sell stocks and buy longer maturity bonds of higher quality borrowers just before a recession starts. And before others recognize the recovery, we’d like to reverse those trades – buying back into stock markets and reducing our interest rate sensitivity in our bonds. Unfortunately, it is impossible to know the timing of market fluctuations with greater certainty than the rest of the market. We may believe that the internet bubble leading into the 2001 recession was obvious, but many bought dot-com stocks based on dreams of doubling their money. We may feel the housing bubble which burst in 2007 was equally obvious, but many invested in securities on the assumption that geographically diverse real estate markets would never drop at the same time. To benefit from timing requires twice having a timely insight ahead of other investors.
A tactical shift out of equity markets too early or too late will lead to poor long-term investment returns. Analysts at JPMorgan calculated the average return of stocks during the twelve months leading up to a market peak was 23%.* Selling out of the stock market just a year before the market high misses out on significant appreciation in the index. After each peak, the average loss over the next twelve months was 14%. While capturing the +23% and avoiding the -14% would be great, selling within days of a market peak and buying back at the bottom is luck. A better strategy is to hold through the volatility, earning both the +23% and the -14% and ending up ahead by 6%.
The lesson of past economic and stock market cycles is that long-term investors are not hurt by recessions if they have an appropriately designed portfolio strategy and remain invested in accordance with that strategy.
Rather than guessing at the timing of the next recession, it is best to use the volatility of financial markets to your advantage:
- Reduce your exposure to higher risk and return investments when they’ve appreciated by rebalancing back to your portfolio targets.
- Have sufficient low-volatile assets to meet your spending needs while stock markets are down.
Maintaining a portfolio’s risk at an appropriate long-term average commensurate with your needs and goals will insulate your wealth from recessions and provide much greater peace of mind.
* based on the S&P 500 Index from 1945 through 2018