When will the next recession be?
Are you worried about the next recession? Many people are.
I suppose it is no surprise as the world seems to be facing endless headwinds that could slow global growth.
Lots of people are worried that the trade war between the U.S. and China, or the unhealthy debt situation in Europe, not to mention Brexit could all tip global economies over the edge!
But well known venture capitalist Chamath Palihapitiya doesn’t think we have to worry about recessions at all. Only last week he was on CNBC arguing that major downturns and expansions are a thing of the past in the western world.
We have completely taken away the toolkit of how normal economies should work when we started with QE. I mean, the odds that there’s a recession anymore in any Western country of the world is almost next to impossible now, save a complete financial externality that we can’t forecast.
Chamath Palihapitiya
So he thinks central banks have made recessions near impossible, as they can now use quantitative easing effectively to control the economy.
It’s just around the corner
But Palihapitiya is definitely in the minority with his views right now.
That’s because not a day goes by without some financial commentator predicting a downturn.
Perhaps you have to take notice when the big guns start voicing their concerns.
Billionaire investor Jeffrey Gundlach pointed to the increasing gap between consumer sentiment and current expectations as the “most recessionary signal at present.”
And he’s in esteemed company.
Speaking to CNBC, Nobel prize-winning economist Paul Krugman said:
(there’s) a pretty good chance of a recession sometime in the next year or so.
Paul Krugman
And Krugman follows another equally famous Nobel prize winning economist Robert Shiller who just last month said:
(there’s a ) greater than average chance of a recession in the next 18 months.
Robert Shiller
OK that’s a score of three one in favor of a recession, but even if we agree with Mr Gundlach and a couple of Nobel Laureates, what does that mean for us as investors anyway?
Why are we asking “When will the next recession be?”
The fact is, investors don’t really need to worry about a recession per se. Instead, we might worry that a recession could cause a bear market!
On average in bear markets stock markets lose 30.4% of their value and then take 22 months to recover.
The idea of our balance dropping double digits is a scary thought for most folks. Some experts think people asking “When will the next recession be?” is enough of a warning to start taking action.
Get defensive
There is a school of thought out there that says we should ‘get defensive’ if we think a recession is approaching.
To a lot of commentators ‘getting defensive’ means looking towards areas of investment that can perform better than the wider market in poor economic conditions.
Healthcare, consumer staples, utilities and commodities have in the past had lower stock price declines during bear markets than other sectors.
The reason for this is that these are things we need whatever the weather! The theory goes that while you may hold off buying a new iPhone when times are tough, you won’t stop brushing your teeth!
Take some risk off the table.
There is another school of thought that talks about adjusting your risk exposure.
It is perhaps championed most convincingly by investing legend and co-founder of Oaktree Capital, Howard Marks.
Marks has been all over the news recently. His message is clear:
It’s time to take some risk off the table. The odds have shifted against you.
Howard Marks
Basically, Marks is of the opinion that the markets have been going up for long time, so it is only a matter of time before they run out of steam. As a result, he believes investors should think about reducing their exposure to riskier assets such as stocks.
If you normally have 80% in stocks and 20% in government bonds, perhaps you should make a change. You could reduce your stocks to 60% and increase your government bonds to 40% for example.
Warren Buffet on risk
Others think bear markets are simply an opportunity to buy cheap stocks. The investing legend Warren Buffet explains it best:
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
Warren Buffet
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period?
Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the ‘hamburgers’ they will soon be buying.
This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
It’s pretty clear that Buffet likes it when stocks go down. In fact, at his company Berkshire Hathaway’s annual shareholder meeting a few days ago he reinforced this idea.
Somebody asked him why he has so much money in short term treasury bills rather than sticking it in a cheap index fund. His response was telling:
You know in the next 20 or 30 years there’ll be two or three times when it’ll be raining gold and all you have to do is go outside. But we don’t know when they will happen.
Warren Buffet
Sounds like Buffet is hoarding cash in anticipation of a recession or bear market in the hope that stocks will go on sale!
Bill Bernstein on recessions
In his excellent book the Investor’s Manifesto Bill Bernstein echoes Buffet when he says:
A 25-year old who is actively saving for retirement should get down on his knees and pray for a decades-long, brutal bear market so that he can accumulate stocks cheaply.
Bill Bernstein
Bernstein does say if you are closing in on retirement, you wouldn’t want a bear market. That said, if you are in the accumulation phase of your investing, stock prices going down pretty much equates to stocks on sale for you.
That doesn’t mean you should rush out and buy stocks every time prices go down. At the end of the day, you don’t know how far down they are going to go. You might buy them today after a 20% drop only to find they drop a further 20% tomorrow.
Deciding when is the best time to buy something goes back to market timing which is notoriously difficult to do.
For most investors, a sensible way to invest is through rebalancing, dollar cost averaging and diversification, so it is worth looking at these three individually.
Why rebalancing guards against the bad times
Rebalancing means realigning your portfolio back to your original investment plan. This is usually a split between bonds and stocks.
So if your plan says you should have 50% in stocks and 50% in bonds, then you should periodically rebalance to this amount. More often than not stocks are going to have performed better over a given period.
Let’s say they’ve done really well over a year. Your stocks have gone up big time. Now you have 70% of your money in stocks and only 30% in bonds.
You should rebalance to get back to your 50/50 allocation plan. You do this by either selling some stocks, buying some bonds or a bit of both.
In a bear market, the situation may be reversed. Your stocks are likely to go down in value in relation to your bonds. So let’s say, it is a bear market and the value of your stocks has gone down. In fact, they’ve dropped so much that now your portfolio is reversed.
You now have 70% of your money in bonds and only 30% in stocks. To get back to your 50/50 split, you need to either sell some bonds, buy some stocks or a bit of both.
The magic of this system is that it forces you to subconsciously buy low and sell high. You don’t need to make a decision, your portfolio is telling you what to do.
Dollar cost averaging to keep you safe
If you dollar cost average and rebalance, a bear market should be a walk in the park for you. Dollar cost averaging is where you drip feed your money into your investments at regular intervals.
Some people do this annually, some people do this monthly. It doesn’t matter how often you do it as long as you stick to the plan.
If history is anything to go buy the stock market is going to go up and down through bubbles and crashes, bear and bull markets. Sometimes you’ll be paying over the odds for your investments, but at other times you’ll be buying bargains.
In the end the price you pay will even itself out over time. This means you’ll end up paying the average price.
Moreover, because the prices tend to go up over time, paying the average price is great. It will enable you to get market returns and the markets have proven again and again that they are generous over time.
Using diversification for added protection
And this brings us to our last point, diversification which Burton Malkiel, in his investment classic a Random Walk Down Wall Street describes as:
The only free lunch in investing.
Burton Malkiel
Diversification is a simple concept. Essentially, don’t put all your eggs in one basket.
Think about this. If you invest in one company and you choose badly and that company goes bankrupt you may lose all your money.
On the other hand, if you invest in 100 companies the chances of all of them going bankrupt are pretty low. Basically, the more companies you invest in the better and safer your investments will be.
I know what you’re thinking….. Wouldn’t it be better to just invest in all the good companies that are going to do well and skip all the bad companies?
Unfortunately, choosing which individual stocks are going to do well is an almost impossible mission for the average investor. In fact, most professionals seem to struggle with it, too.
But according Malkiel, there is one way to guarantee you’ll own all the best companies, and that is to buy all the companies.
If you buy all of them you are guaranteed to own the ones that do well. Yes, you’ll also own some rubbish but the good companies will more than make up for it.
The more companies you invest in, the more diversified you will be. Diversifying your investments into as many companies as you can is a sensible decision. In fact, you don’t need to stop with companies, you can diversify into different business sectors and geographies too.
Nobody knows what the future holds. The stock prices of individual companies crash all the time. Whole sectors go down from time to time and on occasion entire countries’ stock markets go down.
The bottom line
Investing in a globally diversified portfolio, via dollar cost averaging and regular rebalancing should help you to weather the storms which will inevitably come your way.
