“Your money is like a soap bar. The more you handle it, the more it diminishes.” — Economist Eugène 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 has not already begun. For many investors, the instinctive response to an impending downturn is to retreat into a protective stance until the storm has passed. Yet one of the repeated lessons of history is that investors are often their own worst enemy, and attempts to avoid short-term discomfort more often lead to longer-term damage. Too often the adversary is not the economy but our own behavioral psychology.
It is useful to go back and think about what it means to be in a “recession”. Economies are inherently cyclical, with periods of expansion and full employment followed by contractions in output and job losses. Until the beginning of the 20th century, all cyclical troughs were called “lows”. In the wake of the crash of the 1930s, the somewhat more benign term “recession” was widely adopted to describe less severe negative cycles than the Great Depression, but there is no formal 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, wage income and consumer spending. A familiar but unofficial marker of the recession is two consecutive quarters of negative GDP growth, which occurred in the first and second quarters of 2022.
There is no set set of quantitative measures that identify recessions. Indeed, the meetings committee “knows it when it sees it”. Typically, it takes up to a year for the National Bureau of Economic Research to officially declare the start of a recession, sometimes after it is already over. 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 timing using historical data for the 20 years from 2001 to 2020. Case A calculated the hypothetical return of a $2,000 investment each year at lowest point in the stock market, in other words, perfect timing. Case B calculated returns by injecting $2,000 into the market on the first day of each year. While the perfect timekeeper earned an annualized return of 12.5%, the stable Eddie returned 11.6% annually, a difference of less than a percentage point. Of course, there’s a near-zero chance of doing exactly the right thing every time. More importantly, you would need to be accurate nearly 80% of the time for market timing to hold. Good luck.
Not only do active timers need to accurately predict the market top, they also need to correctly recognize the bottom every time at the exact moment of greatest investor pessimism. Numerous simulations show that missing only the 10 best market days over 30 years cuts your total return in half instead of staying fully invested. And remember that half of the biggest gain days for stocks occur during bear markets.
The futility of over-trading to avoid recession-related losses becomes more intuitive once one recognizes that markets do not coincide with recession but lead it. Market prices serve as a mechanism for updating participants’ expectations of fundamental drivers, including corporate earnings. In most cases, the stock market peaks before the official start of a recession. If you wait for confirmation, it is already too late. Meanwhile, in almost every recession, the market bottoms long before the economy begins to recover, about 10 months before the end of the average recession. Are you expecting signs of recovery? You probably missed a third of the winnings.
The overwhelming preponderance of evidence supports staying invested through economic cycles given the immense difficulty of accurately predicting turns. But there are active steps one can take to maximize the likelihood of success. Investment decisions should be informed by a consistent plan that addresses specific financial goals and risk assessments. Creating a diversified portfolio across a wide range of established asset classes and actively minimizing fees and expenses is always the path to success. The dramatic collapse of crypto card house FTX is a reminder that recommendations from quarterbacks or models don’t look like investment advice.
It is also important during episodes of market turbulence to periodically rebalance portfolio holdings against plan objectives, taking advantage of opportunities to add assets at disproportionate discounts and restore the appropriate risk profile. And the heightened risk of an economic downturn suggests an excellent time to shore up personal balance sheets by paying down high-interest debt and cutting controllable spending to help weather the uncertainty.
The United States has endured 14 recessions and 26 bear markets (losses of 20% or more) since 1929. Over the same period, passive exposure to the vast US stock market has generated a cumulative return of 500,000% with dividends reinvested. 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.
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