Are We Headed For A Recession?

As we approach the middle of 2022, many are asking “Are we headed for a recession?”.

Considering recessions are when most investors incur losses within their portfolios, it is worthwhile to invest a few moments to contemplate the question.

After managing investments through a few recessions in the past, I can tell you from experience that the stock market tends to lead the economy both into and out of recessions. Considering the poor performance of stock and bond markets to this point in the year, is a recession already upon us?

How do you define a recession?

A recession is a state of the economy defined by slow or negative growth. More specifically, the National Bureau of Economic Research (NBER) defines a recession as a significant decline in economic activity that lasts for more than a few months. Recession indicators spread across the economy can help us assess whether a recession is taking place. These indicators can include (but aren't limited to):

  • Real gross domestic product (GDP)
  • Rising unemployment rates
  • Consumer confidence and spending
  • Durable goods orders (expensive goods intended to last 3 or more years)

The NBER's Business Cycle Dating Committee keeps track of peaks and troughs in the economy in an effort to pinpoint economic turning points. They provide research free to the public online, which can help those interested in taking a deep dive into historical economic statistics for the United States.

Can we predict a recession?

Predicting the future is always difficult. However, we can always look to the past for patterns that can help us understand what might be happening right now.

First, it's important to understand that, if the general population feels a changing economy in their wallet, it's likely that the stock market feels these effects even more. For instance, if oil prices go up for gas companies, gas prices usually go up for consumers. This can affect consumer spending: to counteract the more expensive gas fill-up, consumers might spend less elsewhere. This can have a domino effect that causes changes throughout the market.

However, consumer spending by itself is hardly an indicator of a recession. Luckily, we can also refer to facts, figures, and patterns.

Head and shoulders patterns are one such example. A head and shoulder pattern can show us the push and pull of the market. In simple terms, this pattern usually indicates a battle between those with high confidence in the market (bulls) and those with low confidence in the market (bears). Because high-confidence bulls tend to buy stock, when they control the market, it often trends up. When low-confidence bears selling their stock control the market, it often trends down.

A head and shoulders pattern lets us see this battle play out through a recognizable pattern that indicates a bull-to-bear market shift. If we look at what preceded the 2007 financial crisis, a head and shoulders pattern served as a prelude to the coming recession. Here, we can see the market break the neckline shortly before the recession:

If we look at recent market trends, we can see a strikingly similar head and shoulders pattern—complete with a recently-broken neckline:

Keep in mind that, while the broken neckline could be the first indicator of a recession, it's still too early to be absolutely certain. However, if the trend continues along its current path, the end result will most likely be a recession. And, since the strength of the U.S. dollar can affect economies globally, it's important to be prepared, just in case.

Bonds share the sentiment

Most importantly, bonds are looking to confirm this. Since the turn of the year, bonds have been giving investors of diversified portfolios a rude and cruel awakening.

This form of “Stagflation” can be detrimental to conservative and even moderate investors as they tend to lose on both sides of their diversification and their accounts become stagnant with losses.

Recently, this out-of-the-ordinary correlation between equities and bonds appears to be changing as investors seem to be starting to accept that the economy could have a "hard landing".

So, if the equity and bond market are giving signs that a recession is here, what does history tell us we can expect?

How does the market respond to recessions?

It might go without saying, but it's still interesting to note: when entire markets go down, the risk to investors goes up. As a result, the market's response to a recession is understandably volatile. Investment decisions come hard and fast. The trajectory of individual stocks can rise and fall greatly in unpredictable patterns. This is usually due to investors marking rapid-fire decisions in an attempt to recoup any losses they may have experienced. Because of the growing uncertainty, the good news about any stock can cause investors to rush toward the hope of potential gains in droves. This can cause temporary spikes in the market. But these trends are often short-lived as the market continues its downward trend.

That up-and-down effect is usually only true of individual stocks. For the market as a whole, we can usually expect sharp declines.

Let's take a look at the way the market has reacted to some of history's worst bear markets:

As you can see, bear markets can often usher in an economic recession. If we're truly entering a bear market, then it's possible that a recession could follow.

So, what can an investor do now that may help their portfolio during a recession?

Investing during a recession

With inflation already affecting our retirement options, learning how to invest during a recession can become an even more important task. Recession investing requires a delicate balance of knowledge, guts, and patience. The risk is high and the eventual payoff is unknowable. However, there are steps you can take to increase your chances of making it through this volatile period:

  • Increase your emergency savings and cash reserves, even if this means you harvest some long-term gains. This can help you meet your other obligations without needing to sell. The extra cash can be used to buy more investments when the recession is in the rearview and recovery is on the horizon.
  • If you have incurred losses or declines in your portfolio, focus on recovery. The savviest of investors know losses and drawdowns happen throughout an investment life and when they happen the best use of energy and emotion is to focus on recovery.
  • Consider organizing the time frame of your assets into buckets and create a new bucket with a 3-7 year time frame. Use this bucket to buy distressed or beaten-down assets that have the fundamentals to recover or come out of the recession in a stronger competitive position.
  • Resist obsessively checking your portfolio.
  • Consider alternatives to stocks and bonds. Many investments that are alternatives to stocks and bonds can provide growth and income during times of recession and inflation.
  • Be thoughtful about your investing discipline and focus on how the timeframe of that discipline aligns with other needs in your life like retirement, health care, or estate succession.

What investments do well in a recession?

Though speculation becomes easier during a recession, it's important to resist that urge, as it can become too much too soon. This is especially true for stocks that went public in the later stages of the bull market. These would-be stocks went public after 2018.

Weaker companies with high valuations tend to go bankrupt during recessions. Remember: during a recession, stocks can drop drastically in price. Though these stocks may seem like a cheap investment at the time, it's very possible that their price has fallen for a reason.

It's still possible to make money during a recession. To do so, consider investing slowly, in increments. This can help you grow your position over time. To find potentially helpful investments, investors will be better served to focus on companies that:

  • Earn and grow consistently over time and are solving a problem or providing a service you can see has a secular growth story behind it.
  • Consistently pay dividends and avoid high leverage. Look for the “Aristocrats” that are consistent at increasing their dividend.
  • Have free cash flow, strong operating margins, and benefit from a secular trend.
  • Depend on consumers or new investors to create incoming cash.
  • Have low cash burn rates and avoid negative earnings.
  • Consider bonds. Recessions create opportunities in both Corporate and Government Bonds that you can’t find in any other time of investing.
  • Lastly, know your alternatives. Some alternative investments can be growth replacements to stocks during and after a recession.

Most importantly: don't panic. Recession investing can be dangerous and risky. News reports are often negative—even drastic. But, with a level head, a strong plan, and some adaptability, you might be able to dodge the worst of what a recession has to offer.

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