Written September 2019
The big topic in financial media these days is whether there is an economic recession coming or not. Multiple countries around the world, including the United States, are starting to flash some recession warning signs.
A well-structured portfolio doesn’t usually need many changes to survive a recession and come out stronger on the other side. However, depending on how hands-on you want to be, there are small changes or strategies you can use to make sure your portfolio is as resilient as possible, without trying to precisely time market movements.
This article covers two main topics:
How to Spot an Oncoming Recession
There are many ways to define a recession. One of the most frequently-used definitions is that a recession is two consecutive quarters with negative real GDP growth. Another potential definition is that it’s a substantial rise in unemployment, by perhaps 2% or more.
However you define it, recessions are rough. People lose their jobs, bankruptcies increase, volatile financial assets like stocks lose a lot of paper value, and government deficits spike to higher levels.
Recessions historically happen every three to ten years in most countries. The United States is currently in the longest period without a recession in national history, at just over a decade.
Usually some of the more cyclical parts of the economy turn down first. They ebb and flow naturally, and sometimes they slow down and speed back up again without causing a broader problem. However, if the slowdown is severe enough or if there is some shock or imbalance in the system, it leads to higher unemployment levels and reductions in consumer spending, resulting in an outright recession rather than just a cyclical slowdown.
This can create a vicious cycle, because when people lose their jobs, they spend money less on non-essential items, and that reduction in spending can result in a sharper downturn in business performance and further reductions in payrolls, which can further reduce consumer spending, and so on…
Usually at that point, governments try to step in and inject some stimulus to revive the economic machine. They might expand unemployment benefits, fund infrastructure projects, or do something else to try to break that negative feedback loop. Due to a reduction in taxes from income and capital gains, along with this extra stimulus spending, government deficits and debts typically increase.
There is considerable debate about what actually causes a recession, but in general, most of nature including human behavior is cyclical. We easily forget the past and make the same or similar mistakes, over and over.
As Howard Marks describes in his book, The Most Important Thing, most people are prone to excess. When the economy is doing well, volatility is low and asset prices seem to keep going up, so investors start to get greedy and make mistakes. They extrapolate that these good times will last for a very long time, and they take on too much debt, make sloppy deals, and don’t protect themselves enough against risk. This inserts a certain amount of fragility into the system, and this fragility can turn a simple slowdown, whenever one happens to come, into an outright recession.
The Folly of Precise Timing
There’s no fool-proof to way to time an upcoming recession perfectly. Each one is different, but they share certain characteristics.
What complicates matters is that based on the definition of two consecutive quarters of GDP declines, recessions are only officially declared in hindsight. And if it gets to the point where the unemployment rate is rising sharply, things are already bad. That’s a lagging indicator, one of the final dominoes to fall.
Plus, the stock market usually peaks prior to when the recession begins. For some examples:
- The official start of the 2007 recession was in December of 2007, but the S&P 500 peaked in October 2007 and declined thereafter.
- The official start of the 2001 recession was in March 2001, but the S&P 500 peaked six months earlier, around September 2000.
So, nobody is going to come around, pat you on the shoulder, and say “Hey buddy, time to take your chips and cash out. A recession is here.” By that time, the damage is done.
And suppose you try to predict it far in advance. Maybe in late 1997, when the Dotcom Bubble was starting to build and the stock market was beginning to reach heights of valuation not seen since 1929, and the yield curve was nearly flat, you decided to take your chips and leave. You cashed out of the S&P 500 when it was in the 900’s.
Well, the market went on to spike to valuations never seen before, and the S&P 500 reached over 1,500. By the time it crashed back down to a bottom in 2003, the S&P 500 was in the 800’s and six years had gone by. Markets can stay weird for longer than you might guess.
Rate of Change Indicators
The recession debate in the financial media these days is confusing for a lot of people, because employment levels are still good, and many areas in the economy are at all time highs. How could we be talking about a potential recession?
The key is to remember that a recession is merely a contraction from all-time highs. It’s the rate of change that matters, so when growth levels start to decelerate it’s an orange warning light, and when they start to contract with negative year-over-year growth, it’s a more serious red light.
Most measures of economic activity are still at high levels. For example, total U.S. construction spending looks pretty good since the last recession, with recessions shaded in gray:
Chart Source: St. Louis Fed
However, the “percent change from a year ago” measure for total U.S. construction spending looks a lot less rosy, as it is just beginning to enter a contraction from its current high point after several years of continuous expansion:
Chart Source: St. Louis Fed
We’re seeing the same thing for many other indicators, such as PMI, capital goods orders, and so forth, although they have been more cyclical in general. For example, here is the rate of change of U.S. industrial production:
Chart Source: St. Louis Fed
We had an industrial production contraction in 2016 when China’s economic growth and commodity consumption slowed down, and oil prices crashed. However, due to stimulus and other factors, the production picked up and resumed growth without leading to a full recession. Currently, we seem to be headed for another contraction in this indicator or at least close to one, and time will tell how this plays out.
The Ultimate Factor
The U.S. manufacturing and construction sectors are already arguably in a mild downturn based on broad economic data, but manufacturing and construction are relatively small parts of the U.S. economy. The healthcare and software industries, for example, are not currently in a contraction.
More importantly, consumer spending represents over two-thirds of U.S. GDP. That’s the ultimate factor; so goes the consumer, so goes the economy as a whole. Year-over-year consumer spending is still strong:
Chart Source: St. Louis Fed
And the year-over-year increases in employed people is still higher than population growth. There are clear signs of slowing, but no major deterioration quite yet:
Chart Source: St. Louis Fed
Unemployment and spending tend to be lagging indicators, as the more cyclical parts of the economy tend to turn down first, followed by job losses and spending decreases if that downturn is severe enough and the shock spreads to the broader economy. Weakening cyclical sectors were not enough to pull down employment and consumer spending during the U.S. economic slowdowns in 2012 or 2016, so we’ll see if 2020 is the third strike for an actual recession or not.
Compared to the previous U.S. slowdown in 2016, we have a few more bearish factors this time around, such as an inverted yield curve, the beginning of a contraction in domestic construction spending, and higher consumer credit levels. The bond market is already trying its hardest to tell us that things aren’t good.
This chart shows the difference between the 10-year yield and 2-year yield (blue line), shows the Wilshire total U.S. market index (red line), and shows recessions shaded in gray:
Chart Source: St. Louis Fed
When the yield curve inverts, that’s the bond market patting us on the back and suggesting that we take some chips off the table.
A way to think about this is that when multiple year-over-year cyclical indicators are starting to go slow down and eventually contract, and the yield curve gets flat and potentially inverts, recession risk is elevated. Often during these late-cycle periods, stock valuations are high as well, which adds further market risk.
How to Fortify a Portfolio Against a Recession
A lot of readers ask me if they should go to cash. Some readers tell me they went to cash during the slowdown in 2016 or another date, missed part of the bull market, and now they’re not sure whether to get back in.
The problem is that as described above, it’s challenging to time a market top. People can lose just as much money trying to avoid a recession as a recession itself causes to a portfolio.
And there are rare types of recessions that are “stagflationary”, where cash itself is unsafe, and it would ironically be better to be in stocks (or real estate, or gold) rather than cash. With debt at record levels and central banks around the world near rock-bottom as far as interest rates are concerned, the probability of a recession turning stagflationary is probably increasing over time.
Strategy 1) Diversify Your Portfolio
The simplest way to ride through a recession is to just have a diverse portfolio. Own some domestic stocks, some foreign stocks, some bonds, some real estate, and some precious metals, and just rebalance through the storm.
For example, a simple 60/40 stock/bond portfolio had about half as much downside during the 2008 financial crisis as a pure stock portfolio, and recovered more quickly:
Chart Source: JP Morgan Guide to the Markets
How defensive you need to be depends on your age, wealth, and goals. If you are young, you can ride out serious downturns and dollar-cost average into them to build wealth over decades. But if you’re within a few years of retirement or already retired, you need to be protected from major market crashes.
Although the S&P 500 recovered to new inflation-adjusted highs within 5 years from the 2008 financial crisis, it took 27 years to permanently reach new inflation-adjusted highs after the 1929 market crash, 23 years after the 1969 bear market, and nearly 15 years after the 2000 bubble.
Looking internationally, the Japanese stock market has been in a 30-year bear market, still far below its 1989 highs. The Stoxx Europe 50, representing European blue chips, still hasn’t recovered nearly 20 years later from its highs in 2000. The MSCI emerging market index has barely reached new inflation-adjusted highs 12 years after its 2007 bubble peak.
Multi-decade bear markets in real terms can and do happen everywhere.
A problem these days, though, is that bonds don’t pay what they used to. In the years leading up to the 2001 recession, 10-year U.S. treasury notes were yielding 5-6%. In the years leading up to the 2008 recession, they were yielding 4-5%. Bonds have historically provided a safe and reliable income stream that was higher than the inflation rate, so seniors could have a large portion of their wealth in bonds, and a smaller portion in stocks.
Now, U.S. 10-year treasury notes yield about 1.5%, which is below the current inflation rate in the United States. European and Japanese government bonds are negative in nominal terms, which has never happened before in history. This makes it harder to get real income and returns from bonds.
There aren’t any easy answers, but a portfolio that includes precious metals and other types of assets is historically able to ride through even more situations than just stocks and bonds. My free newsletter model portfolio, for example, is designed to weather a downturn reasonably well, while still benefiting from growth.
A lot of the stock/bond model portfolios that financial advisers use today for clients were designed decades ago when bond yields were high, and have been considered standard practice ever since. A key property of gold is that it benefits from low interest rate environments, yet it’s barely utilized in any portfolio models.
Personally, how defensive or aggressive my portfolio is at any given time depends on equity valuations, bond valuations, and business cycle developments. I use a low-turnover approach to gradually rotate to where the value is.
When stocks are cheaper and the business cycle is earlier, I am heavily invested for high potential returns. When more and more evidence begins building that we’re in a late-cycle environment, and stock valuations reach uncomfortable heights, I start dialing back my risk and building a defensive element in my portfolio consisting of cash, bonds, and precious metals. Additionally, my stock choices shift to be more defensive as well, with stronger balance sheets and historically strong recession performance.
In other words, rather than trying to time the market precisely, I am always diversified. However, I constantly assess opportunities from regions and asset classes around the world, and allocate to ones that seem to offer the best risk-adjusted returns under the existing circumstances.
Strategy 2) Use a Trend-Following Model
If you want to get fancy, there are ETFs that automatically time the market for you, using trend following. Rather than worrying about when or when not to go to cash, this approach lets you ride an equity bull market and then go to cash when the time is right with a rules-based system.
Suppose that you had a rule where, whenever the S&P 500 goes below its 200-day simple moving average, you sell and go to cash. Whenever it’s above its 200-day moving average, you buy back in.
In that case, you’ll have moderately reduced performance during bull markets due to occasional false signals (“whipsaws”), but will participate in most of the upside (green dots below). In exchange, you have a good possibility of avoiding those giant market crashes. For example, following this method would have gotten you to cash (red dots below) to avoid the bulk of the 2001 and 2008 meltdowns:
Chart Source: Advisor Perspectives
There is a simple ETF called the Pacer Trendpilot U.S. Large Cap ETF (ticker: PTLC) that uses a trend following approach with the S&P 500.
As long as the S&P 500 is above its 200-day simple moving average, it’s invested in the S&P 500. However, when the S&P 500 starts to consistently fall below its 200-day simple moving average, the fund starts shifting to cash-equivalents (ultra short-term treasuries):
Source: Pacer ETFs
Here’s an example of it at work. In the fourth quarter of 2018, the S&P 500 fell by by over 19%, while the Pacer ETF went to cash and only fell 8%:
Because this was only a correction and had a very fast V-shaped recovery, the index quickly caught up and surpassed the Pacer ETF anyway. For reasons like this, the Pacer ETF has underperformed the S&P since its inception in 2015, which is what we would expect in a bull market.
However, if the S&P 500 has a 30%+ crash that takes years to recover from, like it often does during a recession, the Pacer ETF’s defensive positioning should protect investors from the majority of the downfall and recover far faster. The S&P fell over 45% from its 2000 high and over 55% from its 2007 high, although these were larger than average crashes.
Basically, with an approach like this, you sacrifice some gains during bull markets to hopefully protect against a once-a-decade or once-a-generation crash. This company has similar trend-following ETFs for the Nasdaq 100, international developed stocks, and others.
These systems aren’t foolproof, though. There have been wild days in history where markets have fallen tremendously within a single day, which is faster than most trend-following models are designed to react. For example, in October 1987, the S&P 500 fell 20% in a single day:
There are stock exchange safeguards against that now, but even a multi-day rapid and massive sell-off would mess up the plans of many trend-following models. With all of the algorithmic high-frequency trading that exists today, it’s not out of the question for a weird event like this to happen again.
So, while these models can provide protection, they shouldn’t be your only layer of protection. I don’t personally use a trend following approach, but it’s something to consider for people in or near retirement. A hypothetical passive trend-following ETF portfolio could look like this:
This ETF portfolio is diversified, uses a trend-following approach, but doesn’t base everything on trend-following.
It has 50% exposure to U.S. stocks including 20% in the Vanguard Total Stock Market ETF (VTI) and 30% in the Pacer ETF (PTLC). Then it has 20% in foreign stocks, including 10% in developed markets (VEA) and 10% in emerging markets (VWO), and 10% in REITs.
It has a defensive element in the form of 10% gold (PHYS) and 10% 2-year treasuries (VGSH) because, as described above, trend following can’t protect against a particularly rapid sell-off, so it’s good to have some defense already in place.
When times are good and the bull market is alive, this portfolio has 50% exposure to U.S. stocks (VTI + Pacer), 20% in defense, and 30% in the combination of foreign stocks and REITs. During bear markets, the portfolio automatically shifts to only 20% U.S. stock exposure (VTI), 50% in defense including Pacer, and 30% in those foreign stocks and REITs.
This is just a sample, and you could tweak it however you want, including other trend-following ETFs or a more aggressive or defensive versions. It’s just one more tool in the toolbox that’s available for constructing portfolios that meet your specific needs.
We can’t always go around worrying about a recession. Life is about living, and there are opportunities all the time for those that look. It’s a matter of risk management, probabilities, and deciding how aggressively or defensively to play the game.
In a sport, for example, whether you should play aggressively or defensively depends on how the game is going, and what the other team’s strengths and weaknesses are. There is a time for offense and risk-taking, and a time for defense and risk-reduction.
When the economy and the financial markets start to show us some advance warnings that recession risk is elevated, it’s generally a good time to boost your defense, at least to a certain point. Especially if you can’t afford taking on the risk of significant market declines.
Preparing for an economic recession involves more than just portfolio management. The resiliency of your personal financial situation is just as important, and these are good principles to follow in all market conditions. Try to make sure most of these things are in place:
- Your family income is diverse, rather than concentrated in one job, and significantly exceeds your expenses.
- You have no high-interest consumer debt. Any debt is responsible, like a mortgage.
- You maintain a high savings rate during good times, so that you can rely on it during bad times.
- You have at least 3-6 months of expenses in cash and other steady assets, so that you don’t have to sell stocks or other volatile assets at the bottom of a cycle.