The business cycle is something that cannot be cheated. It can be extended as our Central Bank has been instrumental in doing.
The current business cycle just celebrated its 101st month in July.
That is the third longest in history so far!
I would hazard to guess that by the time this cycle ends, it will own the number two spot in history at over 106 months and maybe the top spot at over 120 months. Only time will tell!
The typical stock market cycle usually tops (and bottoms) about 6-12 months ahead of the economic cycle, as you can see in the previous diagram.
As many of you found out in the last Great Recession everything from your job security to the market price of your homes can be affected by such recessionary cycles, especially when our Central Banks are creating economic bubbles.
So, to help you in planning for the next such economic downturn, whether it is next month or next year, here are five ways you can prepare for the next downturn:
1. Build an emergency fund
It is prudent to have on hand 3-6 months of living expenses in the bank in cash or on deposit in case you have an emergency need for such funds from such things as job loss, unexpected illness or other emergencies. Now is time to grow that fund if you do not currently have an emergency fund.
A great goal to start with is the simple goal of putting $1,000 in the bank. 7 in 10 Americans have on $1,000 or less in their savings account per a recent survey. So just reaching the $1,000 market would put you in the upper 30% of Americans.
Next, set your sights a little higher and reach for that 3-6 months of living expenses in the bank.
2. Reduce debt levels
When economies go into recession, jobs are lost, raises are forgone, leveraged deals fall apart, and opportunities vanish for much of the country. It is a great time to be in a position where you have the flexibility to accept a pay cut and keep your job or even transition if you must to a lower paying job to continue to support your family. You cannot do this if every dollar you currently earn is consumed by either debt or lifestyle.
A simple way to attack debt is to do a debt snowball!
The debt snowball is where you pay the minimum on all your outstanding debt except for one loan. On this loan, you pay something extra to pay it off as fast as your cash flow will allow. When you succeed in paying off that loan, apply what you were paying on that debt on the next piece of debt to accelerate its repayment until you have paid off all your debt.
Remember, start with the high interest rate consumer debt first and then move to lower rate debt, including your mortgage if you so choose.
3. Adjust your lifestyle
Another simple thing you can do today to prepare for the coming economic recession is to adjust your lifestyle. Now is the time to start budgeting your spending and knocking off any unnecessary expenses that you don’t really need, such as that gym membership you keep planning to use but never do.
If you can better bring your lifestyle into line with your income, you will enhance your ability to weather the storm when the next recession threatens.
4. Develop exit or hedge strategies
Now is a great time to make sure your advisor(s) have your back. When the next recession comes, we speculate the markets could lose one-half or more of their value.
What is his or her exit strategy? If they don’t have one, it is time to find a new advisor.
Although stock markets have proven they can and will recover, the question is do you have the time in your planning to wait on that recovery?
The average investor waited five years to get back to breakeven following the Great Recession. If you are a baby boomer today, you may not have enough time left until you need those funds to wait on such a recovery.
Most Americans are under saved for retirement so moving to a more conservative allocation may not help you in the long run, plus bond yield are at 30 year lows. What are the odds bond yields continue to fall from here?
In our opinion, you need to be willing to trade out of the market when it is in a confirmed bear market. Without the right tools and models, these can be difficult to identify for the average person or adviser.
5. Change your mindset
I hate to say it but economic recessions provide opportunity to those with the cash reserves to take advantage of them. Yes, you are in a way preying on someone else’s poor fortune but chances are they failed to plan ahead like you when they had the chance.
In the last Great Recession fortunes were made by those who purchased marked down equities at the bottom or real estate at distressed prices.
Will you be the victim in the next recession or the victor?
Let me know if you have comments or can think of other creative ways to prepare for the next economic recession.
Surprisingly the great bubble builders of the past 8 years (the Global Central Banks) are now trying to pump the brakes and quite honestly seem to be ignoring the soft economic and declining corporate earnings data globally.
The Federal Reserve (and for that matter the other major Central Banks across the globe) seem to be scrambling for the proverbial door.
Each seems bent on raising the interest rate they charge their member banks, lessening their asset buying programs and/or even reducing their balance sheet holdings as if scrambling to have ammunition to fight the next economic downturn.
Our own Federal Reserve is the lead provocateur. They have already raised their reserve rate four times since 2015. They have likewise broadcast a series of future interest rate increases that will last through 2018. Most importantly they have announced their intention to reduce their $4.2 trillion balance sheet holdings in U.S. debt securities, but have yet to lay out any specific timetable.
This to us seems crazy given the lackluster GDP growth and weakening corporate data.
Why on earth would you be tightening into a weakening economic cycle?
That is unless you were trying to get some ammunition for the next economic downturn or have political motivations to saddle the current sitting President with an economic slowdown, which for an apolitical agency would seem improbable.
You can clearly see what the markets believe, below, as most fund flows have been into cyclical, defensive and bond proxy sectors since January. This tends to reinforce the idea that market participants are either 1) nervous about the markets, 2) see weakening GDP and corporate data leading to a cycle end, and/or 3) believe the Fed is incorrect in raising rates or that they will ultimately not be able to raise rates as future economic data weakens.
The Fed is not alone as there is talk of pulling back on equity/debt buying programs in both the Eurozone by the ECB and in Japan by the BOJ.
What has this done then to the bond markets? It has made a confused mess of those markets.
On the one hand, you have market participants who are watching the economic data and seeing weakness. This was reflected in falling long-term interest rates (until just a few days ago).
Then you have the Federal Reserve raising rates on the short end of the yield curve.
The resulting mess is a flattening of the interest rate yield curve as shown below in this relative performance chart of the 2-year Treasury divided by the 10-year Treasury yield. In English, this chart shows rising short-term rates relative to longer-term rates which are generally higher due to greater long-term growth expectations. The rising short-term rates leads to a flattening of the interest rate yield curves as the interest rate differential between them shrinks.
If we go back further in history we can see that whenever yields flatten and then rates actually invert, where short term rates are higher than longer term rates, an economic recession is almost guaranteed.
Check out this chart my good friend Leo Cesna provide me (top of next page)!
What we see in this chart is that when yields on the 1, 2, 5, 10, 20 and 30 year treasuries converge, an economic recession has occurred. Maybe not immediately, but sometime during that convergence.
You can clearly see on the right side of this chart that rates are again headed for a conversion that may again spell an economic recession and likely a market decline.
The moral to this story could be that you should enjoy the possible continued rise in the markets over the next 6-8 months, but be preparing for the possible economic downturn that may follow. More on that in our next blog post.
I think it is fair to say that this current economic cycle has surprised most, if not all, investment professionals. Of course, that is what trillions of dollars of Central Bank stimulus will do to a cycle!
In this short piece, I would like to explore what are the odds of continued expansion, what might we expect as this market eventually tops, how deep the eventual bear market may go and where to invest when the air finally comes out of this expansion.
What are the odds of continued economic expansion?
I think the key phrase in this question is odds. As you can see from the table below, we are already in the second longest expansion in modern times.
If you have ever been to Las Vegas, you would then know that this run could continue but with each passing month the odds start to stack against you further and the house odds continue to improve. In this case the house is the Mr. Market as we like to call him.
How might this current bull market end?
As we highlighted in our blog post entitled, Negative Naysayers Beware! (March 27, 2017), we believe the technical patterns are pointing towards a possible market move that could push prices higher into early 2018. That move could take markets up an average of 22.9% from the January 2017 trigger for this technical signal.
We also pointed out that the bureau of labor statistics published a paper by Yale Professor William Goetzmann. In it, he showed that booms are rarely followed by busts. His study of 42 different stock markets from 1900 to 2014 found that booms are more likely to be followed by more booms.
In fact, Professor Goetzmann found that a stock market that’s doubled in the past year is almost twice as likely to double again as it is to get cut in half in the year.
The key question about this research becomes have we already seen our doubling. After all the S&P 500 index is now at roughly 2400 from a 2007-2008 low of 667? I would think again you must factor in one more idea and that is that markets and economies run in cycles. They cannot go up forever!
If we do go up some 22.9%+ over the balance of 2017 this might be just the kind of move we typically see at the top of markets, where they sprint upward to a top and then fall under their own speculative weight.
What does the cycle pattern look like?
A cycle in economic terms is periods of expansion that are followed by periods of recession or contraction. Throughout the past 150 plus years there have many such cycles.
The average expansion has lasted 26-61 months and the average recession 11-22 months.
The markets tend to lead that same economic cycle by about 6 months. If we look at a 20-year chart of the S&P 500 we see these cycles clearly in the bull and bear markets.
I realize this chart is a bit small but you can clearly see the cycles from 1997 – 2001, 2001 – 2009 and 2009 to now.
We also took the liberty of adding two other features to this chart. The first is the red bubbles. If the current cycle were to end today, you can see from these bubbles that each cycle has gotten progressively larger.
The second addition is the blue dotted trend line. This is where we believe markets could be drawn to when this current expansion ends and the bear market begins. If this trend line does represent the next market bottom, we would be looking at a possible 70% drop in the markets from current levels.
Where does one invest while still profiting from the possible short-term market move upward?
As I wrote about in our post entitled, Recency Bias and its Effect on Preserving Capital (January 23, 2017), we believe the one place you do not want to be is in a purely Buy and Hold (passive) strategy when this bubble bursts. Yet that is where most investors are rotating in search of returns today, while ignoring the greater threat that could come tomorrow and that is downside risk.
In that post we demonstrated that the way to invest was to have both passive and active strategies in your portfolio to the manage risk, smooth returns and enhance long-term returns. It’s not one or the other, but both.
However, if you were to invest new capital today in the markets you would have to worry that we are closer to the end of the cycle than the beginning. This would traditionally lead an experienced allocator to divvy up more of the pie to strategies that protect capital than purely try to maximize one’s upside.
Let me show you what I mean.
Let’s look at what performed well in the last two bear markets (2000-2002 and 2007-2008).
Let’s start with the 2008 market decline. In this chart below note who made money while all other strategies lost money.
The answer is the Trend Followers. They have the ability to profit on both rising and falling trends.
Note, the average hedge fund lost money. Maybe not as much as the S&P 500 index (far left), but they still lost money.
Let’s now look at 2000-2001.
In this period the hedge funds did better (middle bar), but the trend followers still did the best.
Funny, do you know who has done poorly during the last eight years of the current bull market. You guessed it! The Trend Followers.
The moral of the story is easy when looking at recent performance of any strategy to let one’s greed cloud one’s judgment. I call this looking in the rear view mirror.
It is therefore imperative to balance that greed with good old fashion common sense and a little dose of fear.
Smart investors must be willing to be diversified and maybe give up some short-term gain to protect capital that then allows them to invest again another day. They must also know where they are in the economic cycle and anticipate where best to position their capital.
Let me know your thoughts in the comments section below.
Past performance is not an indication of future performance and there can be no assurance that the above indexes will achieve results in line with historical results. This blog post is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
The S&P 500 Total Return is a capitalization weighted index of the 500 leading companies from leading industries of the U.S. economy. It represents a broad cross-section of the U.S. equity market, including stocks traded on the NYSE, Amex and NASDAQ. In this particular index dividends are reinvested and added to the index returns.
The SG CTA Trend Sub-Index is designed to track the largest trend following CTAs and be representative of the trend followers in the managed futures space. The index is comprised of the 10 largest managers in terms of assets under management, equally weighted, rebalanced and reconstituted annually. These managers must be open to new investment and report daily returns.
The HFRI Equity Hedge Index is an index of Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short.