Personal Finance: We have met the enemy, and it’s not recession

“Your money is like a bar of soap. The more you handle it, the smaller it gets.” — Economist Eugene Fama The Federal Reserve’s necessarily vigorous response to persistently high inflation has increased the likelihood of recession over the next 12 months if it has not begun already. For many investors, the instinctive response to an impending slowdown is to retreat into a protective stance until the storm has passed. Yet one of the repeated lessons of history is that investors are often their own worst enemy, and that attempts to avoid short-term discomfort more often yield longer-term harm. Too often the adversary is not the economy but our own behavioral psychology. It is helpful to back up a step and consider what it means to be in a “recession.” Economies are by nature cyclical, with periods of expansion and full employment followed by contraction in output and lost jobs. Until the early 20th century, all cyclical troughs were referred to as “depressions.” In the wake of the crash of the 1930s, the slightly more benign term “recession” was widely adopted to describe negative cycles less virulent than the Great Depression, but there is no official technical distinction. In the U.S., the National Bureau of Economic Research is charged with determining the start and end dates for recessions based upon several factors including GDP, employment, payroll income and consumer spending. A colloquial if unofficial marker of recession is two consecutive quarters of negative GDP growth, which occurred in Q1 and Q2 of 2022. There is no defined set of quantitative metrics that identify recessions. In effect, the dating committee “knows it when they see it.” Typically, it takes the National Bureau of Economic Research up to a year to officially declare the onset of a recession, sometimes after it has already ended. This holds a lesson for investors regarding the near impossibility of accurately timing the market around recessions. In 2021, Charles Schwab published a simple analysis of the potential value of market timing using historical data for the 20 years from 2001 through 2020. Case A calculated the hypothetical return to investing $2,000 each year at the lowest point of the stock market, in other words, perfect timing. Case B computed returns from sinking $2,000 into the market on day one of each year. While the perfect timer earned an annualized 12.5% return, the steady Eddie made 11.6% per year, a difference less than one percentage point. Obviously, there is a near-zero probability of getting it exactly right every time. More importantly, one would have to be spot-on nearly 80% of the time for market timing to hold its own. Good luck. Not only must active timers accurately predict the top of the market, they must also recognize the bottom correctly every time at the exact moment of most dire investor pessimism. Numerous simulations show that missing out on just the 10 best market days over 30 years cut your total return in half versus remaining fully invested. And remember that half of the days with the biggest gain for stocks occur during bear markets. The futility of excessive trading to avoid recessionary losses becomes more intuitive once one recognizes that markets do not coincide with recession but lead them. Market prices serve as a discounting mechanism for participants’ expectations of fundamental drivers including corporate profits. In most cases, the stock market peaks before a recession officially commences. If you’re waiting for confirmation, it’s already too late. Meanwhile, in almost every recession, the market bottoms long before the economy starts to recover, about 10 months before the end of the average recession. Holding out for signs of recovery? You probably missed a third of the gains. T he overwhelming preponderance of evidence supports remaining invested through economic cycles given the immense difficulty of accurately forecasting the turns. But there are active steps one can take to maximize the probability of success. Investing decisions must be informed by a coherent plan that addresses specific financial objectives and risk assessments. Creating a portfolio diversified across a broad range of established asset classes and actively minimizing fees and expenses is still the path to success. The spectacular collapse of the FTX house of crypto cards is a reminder that endorsements from quarterbacks or supermodels do not resemble investment advice. It is also important during bouts of market turmoil to periodically rebalance portfolio holdings back to plan targets, taking advantage of opportunities to add assets at disproportionate discounts and restore the appropriate risk profile. And the heightened risk of an economic downturn suggests an excellent time to shore up personal balance sheets by paying down high interest debt and reducing controllable expenses to help weather uncertainty. The U.S. has endured 14 recessions and 26 bear markets (losses of 20% or more) since 1929. During that same span, a passive exposure to the broad U.S. stock market has returned a cumulative 500,000% with dividends reinvested. There should be a lesson in that. “We have met the enemy, and he is us.” — Walt Kelly (“Pogo”)