The word “recession” is enough to make any economist shudder. But sometimes recessions happen and it’s important to be prepared.
In this episode, Marc Bautis explains whether we should be worried about an impending recession and how to combat one if it does happen.
In this episode, you will learn:
- The four phases of the economy and each of their roles
- What could end the “bull market” phase of the economic cycle
- How the Internet and social media can affect the cycle
- And more!
Tune in to learn about the inner workings of the economy and how to prepare for a recession.
Today we are going to put our economist hats on and talk about recessions.
We will cover:
- What a recession is,
- Are we going to experience one, and
- What can we do about it to minimize the impact to our portfolios.
Aric: Those are great and important questions to answer. For our audience members that may not know, can you give us a general definition of what a recession is?
Definition of a Recession
Marc: Recessions are one of these things that we get hammered with all the time if you listen to CNBC, or read the Wall Street Journal. Once a day there is an article or news story that harps on how a recession is coming and the economy is slowing down. It is a scary topic but before we can define what a recession is we have to cover how the economy works as well as what the business cycle is and how a recession fits into it.
Surprisingly, recessions are actually normal. I know it’s a scary term to hear, but they do happen often. There are four phases to the to the business cycle and what we find is that throughout history these business cycles wind up repeating themselves. You can have a period that we are in now which is called an expansion or more aptly known as a bull market. This is when the economy is humming along and everything is great. The stock market is rising and unemployment is low. At some point the bull market hits a peak. That’s the top of the expansion phase Then the next phase we see is a contraction, also known as the recession, where all of a sudden things slow down. Businesses may pull back on their spending. After a period of time in this downward phase we hit a bottom point which is called the trough. And once it hits that bottom point we repeat ourselves and start the expansion, peak, contraction, and trough all over again. This cycle occurs has occurred continuously throughout time.
A recession is defined as when we have two quarters in a row where our GDP or gross domestic product is actually declining.
Aric: Where do you feel we are now within that cycle?
We are actually in the longest bull running bull market since World War II. If you calculate the timing of when the bull market started we are just at about 10 years running. Bull markets historically have averaged about four and a half years in duration.
Aric: What does that mean?
Marc: You really can’t tell. There is nothing that says the bull market is going to end next month, next quarter, next year, or in five years. Even though it is the longest running bull market in history it’s not the best performing bull market in history so we are sort of plodding along.
Aric: Earlier you had mentioned that recession is inevitable. What does that truly mean that it’s inevitable?
Marc: It means that the economy is cyclical and at some point we are going to have a recession. Along with that recession we will see a pullback in the market. The problem is that no one knows when this will happen. If you look at some other countries like Australia as an example: They are currently in a bull market that is over 20 years long.
Bull Markets do not die of old age. A famous quote is that something has to happen to assassinate the bull market.
What brings an end to a bull market?
There are usually a couple of culprits that can end bull markets.
- The first one is when there’s an asset bubble that bursts. The 2001 and 2008 recessions were examples of this. In 2001 we had the internet bubble burst which caused a recession and then famously in 2007-2008 we had the housing crisis.
- The next usual culprit is when inflation gets out of control. Inflation occurs when the prices of goods and services become more expensive. It gets to a point where things become so expensive that people cannot afford things and stop spending money. It costs more to borrow money so consumers won’t do things like buy houses or cars.
- The third usual recession causing culprit are mistakes made by the Fed. The Fed usually tries to help the economy or keep the economy spurring along. But sometimes they will issue monetary policy that actually can cause a recession. We almost saw this in December of last year (2018) when the Fed kept raising rates and said that they would continue doing so in 2019. Those actions tightened up the credit markets everywhere and caused a 10% drop in the S&P 500. There were nervousness about the uncertainty of whether the economy could handle the rate increases. After the pullback in December the Fed quickly reversed course. In January the Fed announced they would take a step back and not only not raise rates, that a rate cut was on the table.
- And then there’s always something unexpected like with the oil prices and an embargo with OPEC. Or when September 11th happened. But I think those types of events are less frequent.
Are any of these potential recession causing areas out there?
Some of the cyclical sectors are the ones that typically burst. Housing isn’t really at an overextended level. If we look at the price of the stock market, we are making new highs but if you look at how stocks are priced relative to their earnings we are not at a historical high. It doesn’t look like a bubble there either.
To summarize it doesn’t look like an asset bubble is going to burst in the near term.
We we really haven’t had any inflation for a while. I think the Fed would actually probably prefer a little bit more inflation than what we’ve had over the past couple of years.
We are finally starting to see some wage growth. A lot of workers haven’t seen raises for a while, but we are starting to see some growth there which is it is a good thing.
You know it’s all in balance or moderation. We want to see some inflation some price increase, but we don’t want to see too much because that’s when everything tightens up.
With geopolitical issues every day there’s a new crisis hitting the headlines. It could something with Russia, Iran, North Korea, or China. We can see a geopolitical event anytime. But again I think that’s the least worrisome area of the different recession causing events.
Aric: Over the last 20 years media access to information has increased so dramatically that I’m surprised that it hasn’t played a bigger part in this. Back in the day I remember when the Iraq war happened in the 90s right. CNN had coverage 24 hours a day and most people could access it pretty easily. So what do you think as far as how much access we have and how much the media seems to like to throw a click bait that may be more shock type news. How do you see that affecting how we deal with when it comes to a recession?
Marc: It definitely is a valid point. We get inundated with this stuff every day. I think that’s part of what we are trying to cover here. Yes recessions do happen. Try to filter out the noise and determine how you should react or prepare for them. I think it is it is important to not try and time a recession. I see people who say that they are going to put all of the money on the sidelines in cash and wait the recession out.
Five years ago people were saying that bull markets was at its end and that a recession was imminent. Let’s time it and get our money out. Except that the stock market has close to doubled since then.
It really is impossible for anyone to the time any of these business phases, however no matter how many times I say it’s a losing proposition to try and time the market people still want to try and do it. It’s been proven that timing these business events are virtually impossible to do.
One of my least favorite aspects of being an advisor is that I can’t control the markets. But before we get into the preparing for a recession one thing I wanted to add is that although there is nothing out there forecasting an imminent recession the one wildcard are the trade issues with China.
So that’s that’s all that’s definitely gotten a lot of media coverage on that. And I think depending upon how prolonged we go with increasing the tariffs on each other it has the potential of causing a recession. We do not export a lot of goods to China. Only about 1% of our GDP. Looking at it quantitatively, trade barriers with China are not really going to have an impact. But what happens if the trade war goes on longer it throws up that uncertainty flag and once the uncertainty flag gets thrown up businesses stop spending, they stop hiring, they stop spending money on research and developing new products and that is what causes the recession. It is definitely something to follow and something to worry about. There is currently a lot of posturing that is going on by both sides. One week we are close to a deal and the next week we are far away. So who knows when or if a trade deal well will happen, but that is definitely one area to follow and then see how it plays out.
It is important to look at someone’s individual situation, which is a good segway into what should we do to prepare for a recession. There are a couple of things involved and not all of it falls on the individual. The Fed does try to help out either by softening the recession or by helping to mitigate the damage that a recession can cause. They usually do this by implementing monetary policy. Their most common strategy when a recession comes is to reduce interest rates. By reducing interest rates that spurs economic activity. Think about someone who is buying a house. If the interest rate they have to pay on the mortgage is 3 percent versus 5 percent it will definitely impact their housing cost each month. With a higher interest rate they are going to have second thoughts about how much a new house is going to cost them. The Fed has tools that it can use but also as an investor we can look at how should we invest or should we invest differently.
It’s not that we are going to try and time the market and predict that a recession is coming. A lot of people think that they should take all of their money onto the sideline. When the recession comes the market drops. Then they say that they will add their money back and invest again.
Three Reasons Market Timing Doesn’t Work
- We never know when that downturn is going to come. It might be five years down the road.
- You have to be right twice. Not only do you have to call the market top, you have to predict when the market is going to bottom out.
- Emotionally it’s extremely difficult to sell when things are high or buy when things are going down.
It’s very easy to have that mentality because it’s just natural. When you see the stock market in a decline you don’t think it will ever stop.
It’s really about creating that investment strategy and sticking to the plan. Recessions are scary, but the four most dangerous words regarding investing are this time is different.
We can go through history and look at previous recessions and while it’s happening you think that this time is different. The market’s not going to rebound and you want out and not have to see the damage. But every single time and recession or correction has happened, it was followed with a recovery. That message is what I try and impress upon the clients that I work with. The markets don’t go up all the time. We have to mentally prepare ourselves for that. But you know when things look as bad as they do, the market and the economy will recover.
But I will tilt portfolios depending upon where we are in the business cycle. If we look at the market and all the stocks that are out there as we move towards the end of a bull market I will shift to either quality or lower volatility stocks. You can classify stocks and in many different ways. But those are factors which I will use to rebalance portfolios or change the allocations as we get farther along that bull market.
Aric: Did you say quality or low volatility companies?
Marc: Yes. There are stocks of companies that exhibit those two characteristics. Quality is a characteristic that you want to look with companies that have a certain level of profitability and sufficient cash on their on their balance sheets so that they can hedge or mitigate against some of these downturns that happen. Low volatility is what we are looking for when a company’s stock prices doesn’t fluctuate as much as the overall market does. Usually companies that exhibit quality or low volatility are not the most sexy high flying tech startup that just IPO’d, but they are a company that has a great business model or is in a sector where no matter what happens with the economy people are still going to use their service or product You can think utilities like the electric company or consumer goods products like diapers or toothpaste. If the economy has a pullback are you still going to light your house or are you still going to brush your teeth? Those types of companies don’t usually see as much of a hit in a recession.
Those are two ways that we look at shifting the portfolios. It’s not a major shift where we are taking everything out of one strategy and moving into another. They are small tilts or shifts. When we are in a full blown expansion or bull market we’re looking at these high growth or momentum companies who are doubling their earnings every couple years or these smaller cap, hyper growth companies.
How Bonds Can Prevent A Disaster In Your Portfolio
Marc: The last piece of investment portfolios I want to talk about is fixed income or bonds. It’s no secret that the interest rates that investors are getting right now from fixed income investments: look at interest rates that you’re getting all the way along from you know a savings account where the interest rate is next negligible to treasuries which are U.S. governments as a fixed income securities or even corporate bonds and they’re still really low. So some people will say well why would I want to you know why would I even bother with that. And I think part of it is we forget what happens during these recessions or even worse a bear market where stocks do get to get hit. The fixed income piece or the bonds can almost serve as insurance against that and it’s not that you’re going to make some great income from it. But what happens is when the Fed goes and lowers interest rates the price of the bonds actually rises up. So there is an inverse relationship between interest rates and the price of bonds gotcha. So what happens is you will get the price increase with the bonds which will negate the decrease that we’ll see with stock. So it serves as that you know insurance or hedge to help out. So even though you’re not collecting a lot of income it it is a valuable tool to use in a portfolio. Nice. All right. So you know that rapid a lot of this this up. We can’t control economic cycles we can’t control the stock market we can’t control headlines from the from the media and we went over a couple of times how market timing is unrealistic but you can control what’s in your portfolio. So your your plan really should look at your time horizon whether this is is you know your investing or saving for a goal that’s a year away or five years away or for retirement which may be 20 30 40 years away. You know you want to invest differently. You also want to take into account your risk tolerance and that goes to you know how much risk you should have in your portfolio versus how much risk you’re comfortable with and there should be a correlation between those and then really you know back to what you’re what you’re saving for. Are you trying to save for your kid’s college or trying to save for a new house for retirement? There are lots of different goals that one could be saving for. There are always risks with investing but you want to tailor your portfolio to what makes sense for that individual investor not you we want to try and time the market are looking for. We don’t execute a blanket approach where we say everyone who is 50 gets a blanket approach. It is really customized advice for each of our investors.
Aric: The bottom line is that if you’re listening to this, it’s not one size fits all. Marc I know that you work extensively with your clients figuring out exactly what their needs are desires are and how that all plays into their overall plan. If someone is listening they want to reach out to you how do they get to hold you?
Marc: You can either call me at 862-205-5800 or go to my website bautisfinancial.com and schedule a free consultation. There are lots of things we can talk about in that first call but one of the areas we can cover is what you are currently doing with your finances and how your investments are positioned. It’s important to know where you stand now and address any weaknesses rather than waiting for a pullback to happen. We’ll stress test against some of the things like recessions or interest rates spiking upwards. How would your investments fare if we saw another housing crisis like in 2008?