By Matthew Gaude & Shawn McGuire
With unprecedented inflation, rising interest rates, and a rocky geopolitical landscape, it’s hard to predict what the future holds. We all feel the weight of this uncertainty—especially the markets. Recession warnings are exploding across the media, as prominent firms such as Goldman and Citi have increased their assessment of recession risks over the coming quarters, while former NY Fed President Dudley said that a recession in the U.S. was “inevitable” in the next 12-18 months as the Fed raises interest rates higher to break inflation. Given this prevalence of recession warnings in the financial media, I wanted to explain exactly what a recession is, and more importantly what they mean for stock returns, historically speaking.
What Is a Recession?
A recession can only be determined by the National Bureau of Economic Research (NBER), which is a private non-profit organization that conducts economic research and, most notably, decides when recessions start and end. Broadly speaking, a recession is popularly defined as two consecutive quarters of negative GDP growth, although that is not the only way the NBER can determine whether a recession has occurred. For instance, we had negative GDP growth of -1.6% in Q1, but not because the economy was shrinking. Instead, it was because of a massive increase in inventories and trade balance. The “real” economy grew solidly in the first quarter. The point being, while generally two consecutive quarters of GDP declines define the start of a recession, it’s not a hard and fast rule. Importantly, you’ll notice that I said in the previous paragraph that a recession is “defined” by the NBER—as in the past tense. The NBER is not a predictive research organization, at least not when it comes to a recession. In fact, recessions are often identified by the NBER long after the real slowdown in the economy has ended and the recovery is underway!
Just look at the most recent recession in early 2020 when COVID-19 emerged and much of the nation – and the world – shut down. The NBER said that recession lasted from February to April 2020, making it the shortest recession on record. They made that declaration on July 19, 2021… more than a year after the fact.
How Do We Know If We’re In a Recession?
From a statistics standpoint, manufacturing will decline. Additionally, unemployment will rise, Anecdotally, we’ll also see it in our real lives. Construction around town will slow. People we know will lose jobs or have “bad” years. Prices for recreational items will begin to decline and they’ll become “buyer’s markets” (remember those). The U.S. economy has experienced 12 recessions since World War II, and each one included two features: Economic output contracted and unemployment rose.
Today, something highly unusual is happening. Economic output fell in the first quarter and signs suggest it did so again in the second. Yet the job market showed little sign of faltering during the first half of the year. The jobless rate fell from 4% last December to 3.6% in May.
It is the latest strange twist in the odd trajectory of the pandemic economy, and a riddle for those contemplating a recession. If the U.S. is in or near one, it doesn’t yet look like any other. CNBC ran an article last week titled “People are having their job offers rescinded days before they start.” Some companies, especially in the tech sector, have given indications that they’re pulling back on hiring, though across the broad economy the job market has rarely looked stronger. Over in the crypto sector, companies announced more than 1,700 layoffs in June alone. These cuts have come from Gemini, Crypto.com, BlockFi, and Coinbase, among others. And it’s not just tech-focused VC and crypto jobs. Last week, we learned that JPMorgan Chase is laying off more than 1,000 mortgage workers, Netflix is laying off 300 employees, and Tesla will lay off 3.5% of its total workforce.
What’s the Takeaway?
First, while recession is a major buzz word right now, don’t let it significantly scare you. Recessions themselves are arbitrary designations, and the economy slows well ahead of any official recession. More importantly, market declines occur long before recessions are declared. That’s at least partially why stocks are down so much year to date, so to a point at least some of any recession is already priced in. By the time the economy is in “recession” stocks may well have bottomed and will be looking towards the recovery. Second, history implies the duration of the recession is what matters and not whether a recession actually occurs. Again, recessions are mostly caused by the Fed (or Washington more broadly). The recessions of 2001 and 2007-2009 were more driven by bubble bursts that combined with Fed rate hikes to hurt the economy, something that isn’t exactly applicable to today’s situation (we’re in a much more traditional “high inflation/rising rates” type economy). The takeaway is this: The Fed needs to be aggressive; they need to break inflation as soon as possible, almost regardless of the short-term economic fallout, and then get to a point where they have tamed inflation and can again cut rates to support growth (hopefully in late 2023 or early 2024). An economic slowdown is now inevitable, and stocks are pricing that in. History implies the key going forward will be to break inflation quickly and decisively, so relief can be given as soon as possible.
The Timing Mismatch Between the Economy and Your Portfolio
The economy and the stock market don’t operate on the same timeframe. Wall Street is always forward-looking. Because of this, when there are economic storm clouds on the horizon, the pain starts earlier for stocks. But the flip side is equally true — the pain ends earlier.
So, how do stocks perform when the economy is faced with a recession?
But even in a recession – which you would think spells guaranteed disaster for stocks – history’s lessons may surprise you.
The S&P 500 surprisingly rose an average of 3.68% during all recession periods since 1945. That’s because markets usually top out before the start of recessions and bottom out before their conclusion.
In other words, the worst is over for stocks before it’s over for the rest of the economy. In almost every case, the S&P 500 has bottomed out roughly four months before the end of a recession. The index typically hits a high seven months before the start of a recession.
In fact, stocks can even move higher during recessions. This data from Hartford Funds shows that stocks advanced during seven of the 13 recessions since 1945. The overall average for the 13 recessions since 1945 is +3.7%. Of the seven when stocks were up, the average gain was 16%. And of the six when stocks lost ground, the average was -10.7%.
What’s more, the market is often higher – and sometimes a lot higher – by the time a recession is “officially” declared over. That’s the rearview nature of recessions, and investors never want to look in that mirror. It’s important to remember that recessions are the ultimate end result of policy mistakes. Either the Fed tightens rates too quickly or too much and/or we get some Federal policy change that causes economic catastrophe.
There is no better illustration than this picture. This describes the worst job losses we have ever seen, yet the stock market had its best week since 1938 back in March 2020. If you remember back in 2009, the market bottomed in March, yet we were bombarded with increasingly worse economic news coming out for the remainder of 2009, along with record bankruptcies being filed in 2009 and 2010. Yet, the market was already rocketing higher during that same time.
If you were basing your investment decisions upon the fundamental perspective at the time we were striking the lows in March 2009 – or even any part of 2009, then you would have missed the first 100% rally in the market, and maintained your bearish stance for quite some time beyond. In fact, even as we moved into 2010, the market only provided us with a shallow pullback due to the continued excessive bearishness which was based upon those same economic fundamentals, whereas the market continued rallying for many years thereafter.
The folks at Bespoke put out interesting data last week that looks like a bit of a silver lining. They calculated that the S&P 500 has fallen more than 20% in the first half of the year eight times since World War II. It is up both six months and one-year later every single time, with the average six-month gain a solid 21.5%.
We don’t make investment decisions based on what everyone else is doing or what’s popular in the investment industry. Whenever we make planning decisions with you and offer investment recommendations, we do it with your goals at the forefront. When the markets get shaky, we go the extra step of reviewing your objectives to make sure you’re still on track and make educated decisions that are not based on panic or emotion.
This starts from the very beginning of our relationship with you. We use conservative return numbers when analyzing the potential outcomes of your plan because we know that corrections and bear markets will come again. We also use asset allocation “buckets” that divide your wealth into short, intermediate, and long-term strategies to help you make the most of a volatile market.
And in times like this, it’s even more important to have an emergency fund or a percentage of your portfolio that is either in cash or liquid enough if you need it for unexpected circumstances. While cash investments may not provide a lot of growth, having a cash contingency fund with at least one year’s worth of living expenses will protect you against having to sell investments at low values to free up cash.
During bear markets, it’s important to remember that investors only realize losses when they sell, so it’s critical not to sell when the market is down. When you need to access your money is an important factor in avoiding those losses. For example, if you are a decade or more away from retirement, you can likely wait out a recession or correction and benefit from the recovery. If you need access to your funds in the next five years or are within your first five years of retirement (frequently known as the “fragile decade”), (1) a recession will make more of an impact on your money and your plans.
From a practical perspective, we make sure your portfolio’s allocation is set up with your time horizon in mind. If you need money in the short term, your portfolio will hold safe investments like cash or short-term bonds. Because retirement can last decades, you still want some of your money in investments that will produce long-term growth, but your portfolio will look very different from that of a 40-year-old in the peak of their working years.
We Are Your Emotional Support System
One of the most important rules in investing is to refrain from making emotional decisions. It’s easy to get swept away emotionally when the market wreaks havoc on your finances. But if you stay true to your investment strategy and avoid making decisions when emotions are running high, you won’t run the risk of losing even more.
Remember, bear markets and recessions have happened before and they will happen again. As long as you have created a disciplined financial plan and have a trusted advisor who is monitoring your money, you are doing your part to prepare. If you don’t have someone you can turn to when the market gets wild, we’d love to support you and help you build your finances for a strong future. Reach out to us today by calling our office at 770-552-5968 or emailing [email protected]. Or, if you prefer, you can simply click here to schedule an appointment online.
Matthew Gaude is an *investment advisor representative and the co-founder of Live Oak Wealth Management, a financial services firm in Roswell, Georgia. He serves the planning and investment needs of corporate employees, those approaching or in retirement, and 401(k) plan sponsors. Working first as a commodity broker and then as a Business Development Manager for a national broker-dealer in previous jobs, he has the insight and experience to help clients understand the complexities of the market and implement strategies to minimize risk. To learn more about Matthew, connect with him on LinkedIn or visit www.liveoakwm.com.
Shawn McGuire is a financial advisor and the co-founder of Live Oak Wealth Management, a financial services firm in Roswell, Georgia. He serves the planning and investment needs of corporate employees, those approaching or in retirement, and 401(k) plan sponsors. He has worked in financial services since 2002 in positions ranging from financial advisor to stock broker and portfolio manager. As a CERTIFIED FINANCIAL PLANNER™ professional, he is trained to help clients with virtually all their financial needs. To learn more about Shawn, connect with him on LinkedIn or visit www.liveoakwm.com.
Securities offered through American Portfolios Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through *American Portfolio Advisors, Inc., a SEC Registered Investment Advisor. Live Oak Wealth Management, LLC is independently owned and not affiliated with APFS or APA.
Any opinions expressed in this forum are not the opinion or view of American Portfolios Financial Services, Inc. (APFS) or American Portfolios Advisors, Inc. (APA) and have not been reviewed by the firm for completeness or accuracy. These opinions are subject to change at any time without notice. Any comments or postings are provided for informational purposes only and do not constitute an offer or a recommendation to buy or sell securities or other financial instruments. Readers should conduct their own review and exercise judgment prior to investing. Investments are not guaranteed, involve risk, and may result in a loss of principal. Past performance does not guarantee future results. Investments are not suitable for all types of investors. Seek tax advice from a tax professional. Neither APFS nor its Representatives provide tax, legal or accounting advice.