Is Your Portfolio Ready for the Next Economic Recession?
Economists define economic recessions as a period of temporary economic decline during which trade and economic activity are reduced - generally confirmed by a fall in GDP (Gross Domestic Product) in two successive quarters. Recessions are inevitable so if you intend to invest and grow your money for long-term goals such as retirement or growth, you have to be able to have an investment approach that is anti-fragile enough to withstand recessionary periods.
While the likelihood of recessions is almost certain even for healthy and dynamic economies, their timing is notoriously difficult to predict. As Paul Samuelson, winner of the 1970 Nobel Prize in Economics once quipped, “the stock market has predicted nine of the last five recessions.” His point was that market timing and forecasts are often wrong and unreliable. Thinking that you will be able to cash out of your investments and get back in at exactly the right time is a fantasy pursued by many that turns out ultimately to be unrealistic and foolish. So if timing isn’t the solution, how can thoughtful investors prepare their portfolios through these occasional downturns? Read on below as we outline three specific strategies you can utilize to prepare yourself to survive and thrive during more difficult times.
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The chart below summarizes the timing and duration of the four recessions that have occurred in the US since 1980.
Decrease in GDP
Dec 2007 to June 2009
Mar 2001 to Nov 2001
Dot-Com Bubble and 9/11
July 1990 to Mar 1991
July 1981 to Nov 1982
The good news for long-term investors is that recessions are not usually that long (typically lasting from 8 to 18 months before economic activity begins to turn upward again). In contrast, growth periods are far longer and also occur more frequently. This explains the general upward trend of markets that long-term investors can harness to grow their investments over time.
However, while the duration of recessions is actually not that long, the impact on unemployment and stock market valuations can be far more severe than you might think by looking at the table above. For example, during the 2007 to 2009 recession, GDP only declined 5.1%, in contrast, US Stocks as measured by the Dow Jones Average fell almost 10x or approximately 50% from a peak in October 2007 to its low in March 2009. Of course, if you had the stomach and ability to have been prepared after this last recession ended, however, you would have enjoyed an increase of over 350% since then in the Dow Jones with dividends reinvested.
By a number of metrics, the current growth cycle which started in June 2009 is one of the longest continuous expansions in the last century. Known as the Great Recession caused by the Financial Crisis, this last downturn prompted almost unpresented government and central bank interventions that many believe have caused structural issues that have yet to be fully addressed.
As of the date of this article, the next recession may be long-overdue. On average, in recent times, we’ve had a recession every seven to eight years. However, it has been more than 10 years since the last recession officially ended in June 2009. In many countries, interest rates are actually negative and the recent trade frictions between the US and China may also have slowed economic activity between two of the most important global economies and their allies increasing risks of a recession going into 2020 which is an election year in the US.
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Will your investment strategy survive the next recession?
A strategy that can survive and thrive during a downturn is an essential aspect of portfolio planning. In a bull market, every portfolio looks good, or as Warren Buffet has put it, “Only when the tide goes out do you discover who’s been swimming naked.” During the last crisis that ended about a decade ago, many investors found themselves unprepared and suffered devastating losses as a direct result of their inattention or inability to stick to the right portfolio strategies and investment approach.
Historically, there has been a correlation between asset class performance and phases of the business or trade cycle, for asset performance can be impacted by economic factors, such as corporate earnings, interest rates, and inflation. These forward indicators are helpful, sometimes, in identifying the current phase of the business cycle.
Summarized below are three strategies to prepare yourself and your portfolio for difficult times:
Strategy #1: Diversification and your mix between stocks and bondsGenerally, stocks do better when the economy and their earnings are growing. Business confidence and investment is at its highest then and so too, unfortunately, is “irrational exuberance” so naturally valuations and stock prices go up. On the other hand, when a downturn threatens, business expectations fall and valuations and stock prices soon follow. By contrast, bonds and other debt exhibit an inverse pattern, typically yielding more modest returns during good times, but providing greater income and stability during downturns. Having the right mix of these two asset classes as well as a well-planned diversification of investments within each category is an important aspect of being ready for economic downturns.
Strategy #2: Income and Dividend InvestmentsInvestments that pay interest and or growing dividends can be another way to protect yourself during recessionary times. At Ridgewood Investments, one of our focus areas is to identify investments that pay good dividends with the prospect of growing those dividends for a long-time to come. To some extent, bonds, preferred stocks, convertible stocks, and private investments such as income producing real estate or private debt or stable private businesses that generate income also share some of these stable income producing characteristics. The common factor between and among all these investments is that you can own them for the long-term and live off the income stream or actually use the income to take advantage of the opportunities to “buy-low” that might be created during recessionary times.
Bonus Strategy: Options as Portfolio Insurance
Options are a type of advanced financial instrument that can be used to hedge risk and contain short-term portfolio losses. Think of them as a type of insurance. If nothing bad happens, you won’t need them. However, if stock prices fall, they can cover some or all of your loss. Just like insurance, you have to pay a premium to own the option protection. Most of the time, the cost of the premium is paid and lost without a corresponding payoff because the downturn doesn’t happen during that time period of coverage. As a result, this approach can, over time, be a relatively expensive way to protect yourself and so should be used sparingly and in the right hands. A detailed discussion of options is beyond the scope of this article, however, so we mention them just for completeness.
Summary and Next Steps
If you want to achieve your long-term goals, there any many options to consider. As with most things in life, an ounce of prevention is worth a pound of cure. If you wait until the next recession starts hoping you are prepared, it will probably be too late.
As experienced investment advisors, our team at Ridgewood Investments has the knowledge, tools, and expertise to assist our clients to be better prepared when others find out, only far too late, that they have been swimming naked.
Contact us for a complimentary in-depth portfolio review and a further discussion of additional strategies that you can use to be prepared before the next recession arrives.
About the Author
Kaushal “Ken” Majmudar, CFA founded Ridgewood Investments in 2002 and serves as our Chief Investment Officer with primary focus on managing our Value Investing based strategies. Ken graduated with honors from the Harvard Law School in 1994 after being an honors graduate of Columbia University in 1991 with a bachelor’s degree in Computer Science. Prior to founding Ridgewood Investments in late 2002, Ken worked for seven years on Wall Street as an investment banker at Merrill Lynch and Lehman Brothers where he has extensive experience working on initial public offerings, mergers and acquisitions transactions and other corporate finance advisory work for Fortune 1000 companies. He is admitted to the bar in New York and New Jersey though retired from the practice of law.
Ken’s high level experience and work with clients has been recognized and cited on multiple occasions. He is a noted value investor who has written and spoken extensively on the subject of value investing and intelligent investing. He has been a member of the Value Investors Club – an online members-only group for skilled value investors founded by Joel Greenblatt, SumZero – an online community for professional investors, and has also written for SeekingAlpha – among others. Ken is active in leading professional groups for investment managers as a member of both the CFA Institute and the New York Society of Securities Analysts.