The word “recession” is being bandied about these days. How should investors react?
They could choose to ignore it and continue to employ a pure “buy and hold” strategy, which will likely generate solid returns over the long run. But many investors don’t have the wherewithal—either in faith or in the cash necessary to stay afloat—to weather a steep, prolonged drawdown.
That leads us to the question: Is there a good time to step away from equities to avoid sharp losses?
Some investors monitor macroeconomic signals in an effort to predict when the next recession will hit. Others largely shrug it off and focus more on companies’ ability to earn profits.
If one could choose, are you better off knowing a recession is around the corner or knowing that earnings will fall? Bernstein economist Philipp Carlsson-Szlezak addressed that question in a research report this week.
It’s challenging to predict either of the two, of course. An omniscient investor over the past 150 years who switched into bonds when earnings were about to fall more than 7% in six months’ time—and went back into the S&P 500 six months before earnings were about to rebound—would have generated an annual return of 12.1%, according to Carlsson-Szlezak. An investor who simply ignored the earnings cycle over that period and held the S&P 500 index (.SPX) throughout that period would have generated a return of 9.1% a year.
On the other hand, if an investor had shifted into bonds six months before a recession hit and went back into the S&P 500 six months before it ended, he or she would have generated an annual return of 12.8%.
There’s an even better way to play recessions—if you know what type of recession is coming. While each recession is unique and none is caused by one single reason, they each have a leading dynamic that leads to different stock-market reactions.
Looking at U.S. history since 1900, Carlsson-Szlezak categorized recessions into three groups: real-economy recessions, policy errors, and financial crises—“the good,” “the bad,” and “the ugly,” respectively—given the associated equity-market drawdowns for each type.
Among the 22 recessions since 1900, nine were real-economy recessions as a result of aging expansions, nine were caused by Federal Reserve policy errors, and four are considered financial crises that stemmed from the bursting of a speculative financial bubble. The three groups have seen the S&P 500 tumble an average of 23%, 30%, and 42%, respectively, before eventually bouncing back.
To be sure, the actual outcome can be volatile, and this exercise is in no way meant to be used to predict returns. But the high-level takeaways are clear, says Carlsson-Szlezak: Knowing both earnings dips and recessions helps, knowing recessions appears to help a little more, and thinking about recession types helps even more.
“We think considering drivers of recession and thus recession types is superior to a binary, top-down ‘recession risk’ narrative,” he wrote. “When assessing recession risk, wouldn’t we want to be able to point to a cause?”
Where are we now in the current cycle? It seems there are no major imbalances in the market that could disrupt the economy and end the cycle when suddenly unwound, according to Carlsson-Szlezak.
Investment and borrowing activities are moderate, household savings are higher than the historical average, and housing activities aren’t excessive. Financial risks seem to be contained, too, with banks much better-capitalized and funded than in the past.
While many investors are concerned about the level of corporate debt, such borrowing has largely gone into mergers and acquisitions, dividends, and share buybacks and off banks’ balance sheets. That means if these debts fell into default, they’d have a limited impact on the broader economy. Policy risks are also down, as the Fed has pivoted into a dovish stand since early 2019.
Still, that doesn’t mean we’re safe from a recession. As the unemployment rate falls to historic lows and the labor market becomes increasingly tight, economic growth has to slow down, as we are seeing now, which makes it less able to absorb shocks. “What’s absorbed at 3% growth can be the recessionary shock if the economy is only growing at 2%,” wrote Carlsson-Szlezak.
In such a “tight-economy soft landing,” says Carlsson-Szlezak, equities tend to do all right. After all, he points out, about one third of bear markets are not accompanied by a recession at all, and about one third of recessions don’t coincide with a bear market.
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