10540 Marty Street,
April 2022: The Rising Risk of Recession (2.0)
Year-to-date through April 6th, the DOW and S&P500 indices are down 5.71% and 6.24% respectively. This is definitely a bad start to the year but the US stock market has seen many worse first quarters. According to AWealthofCommonSense.com, a financial website, Q1 of 2020 saw a decline of 19.6% and Q1 of 1938 saw our stock market decline 18.6%. Normally you wouldn’t be surprised to receive an email from me communicating the possible reasons for the sell-off and a message trying to put the selling in historical perspective, encouraging you to not only stay calm but to also consider investing more to take advantage of the dip. I last sent an email like this to all clients in late January/early February of 2018 when I communicated that it would likely to be a correction rather than the start of a bear market given the economic data I was seeing at the time. Just like my message in August of 2019, however, I believe this time may be different unless something changes fairly dramatically for the better.
There are several reasons for the market decline so far this year. First, inflation (both the core rate in the news AND the CPE which the Federal Reserve, aka “the Fed”, uses) has risen to its highest rate since 1982. Second, the Fed has begun embarking upon a series of rate hikes which will likely send other rates (like mortgage rates, credit card rates, auto & business loan rates, etc.) higher. The Fed only controls the Federal Funds Rate (FFR), but this rate has historically been highly influential on other rates which they do not control. As rates (to borrow money) rise, economic activity typically declines as companies and consumers borrow less and therefore tend to spend less. Third, the war in Ukraine has caused raw materials exported by Ukraine (seed oils, wheat, iron ore, & neon) & Russia (oil, natural gas, coal, & wheat) to skyrocket in price and fuel to the inflation fire mentioned above. Fourth, both the monthly survey of business owners (National Federation of Independent Business Owners) as well as the monthly survey of consumers (University of Michigan Consumer Sentiment Survey) have been steadily declining in recent months. Declining business owner and consumer confidence surveys have usually been a leading indicator prior to a recession beginning. Recessions, unfortunately, usually bring bear markets with them. According to DQYDJ, a financial website, we have had twelve bear markets since 1950 and eight of the twelve (75%) had a recession begin shortly before or after the start of the bear market. Again according to DQYDJ, the average “max drawdown” of the S&P500, or decline to its lowest point, was 34.24%. The least of these was 20.36% (1991) and the greatest of them was 57.69% (2009).
Why do I believe a bear market may become a reality in the next year or two? First, there’s the aforementioned, very high (and rising) rate of inflation which will likely cause consumer spending on discretionary items (those items that are not absolutely necessary as opposed to housing costs, utilities, food, etc.) to decline. Additionally, after an initial spike using savings & government assistance, sales of autos & light trucks are once again on the decline. Another negative is the fact that once our Covid Recession ended, our trade deficit has exploded upward. This means that we are importing more goods from other countries than we are exporting and this has a negative impact to our Gross Domestic Product (GDP). An additional concern is that retail sales net of inflation (aka “real retail sales”) have been on a slow decline over the past twelve months. Prior to past recessions, Real Retail sales has tended to be one of the early indicators of an impending recession. The most concerning of all, however, is the “inversion” of the US treasury yield curve which took place last week. This means that longer-dated treasury bonds such as the 10-yr treasury note has a LOWER interest rate than a shorter-dated treasury such as the 2-yr treasury note. As you would expect, it is VERY unusual for an investment locking your money in for a much longer time period to yield LESS than a similar investment of a much shorter maturity. Since this link between yield curve inversions and recessions was discovered in the mid 1980’s by Campbell Harvey, a Duke University finance professor, it has been an extremely reliable harbinger of a coming recession. It also proved an accurate forward indicator for the 2020 recession, though some believe that it may not have occurred had the economy not shut down due to the pandemic. Unlike the previous eight inversions, however, the 10-yr and the 3-month treasury rates have NOT yet inverted (and are not close to inverting at this time though that could change in the months ahead) which could turn out to be significant and may reduce the likelihood of a recession taking place.
Could it be wrong this time? Sure, it is absolutely possible. To my knowledge, there is no one piece of data that has ever been 100% reliable when it comes to predicting recessions. However, when you consider other data points mentioned above, and the yield curve inversion which took place last week, the more conservative position would be to expect a recession in the next 6 – 30 months. According to Kiplinger, a financial website and monthly publication, the average time between an inversion and the start of a recession is 22 months. And because bear markets so often take place around recessions, one might also expect for a bear market to start within the next 6-30 months. In fact, it’s possible that the S&P500 has already peaked; of course, we can’t possibly know at this time – only time will tell. What if the treasury yield curve changes in a way that the yield curve is no longer inverted…does this mean that we will we avoid recession? Not necessarily. It’s common for the yield curve to “right itself” before the recession occurs, sometimes as a result of the Federal Reserve lowering the Federal Funds Rate (short-term rates) in hopes of avoiding a recession. In the past, just because the yield curve was no longer inverted did NOT mean that a recession would be avoided.
What to do about it? That’s the $64,000 question. Everyone’s financial situations and goals are different and so there’s not one answer. For example, a young investor who has little invested, a long timeframe for his or her goals, and is making monthly contributions would likely be best to ignore the information above and keep investing as they are when they have the money available. An investor who is middle-aged and has a large amount of money invested might want to reduce the investment risk on their existing, retirement investments but continue to invest new monies with more risk to take advantage of potentially lower prices ahead should the market decline continue. Additionally, as the market declines, they may benefit from gradually raising their risk level to have their larger retirement account(s) buy more risk assets as prices decline. A person in his or her retirement years who will soon begin taking distributions or has already begun taking distributions AND cannot or does not want to go back to work may want to reduce the market risk to their investments to reduce the potential for paper losses, again gradually raising their risk level as prices decline so as to “buy on the way down”. If one is investing for college and/or graduate school, or some other goal like a house down-payment, with a shorter in timeframe than retirement, one must usually be even more conservative since the money needs to be there sooner and is typically distributed over a fewer number of years. One should never raise the risk level above his or her maximum he or she can tolerate as it relates to paper losses whether this is before, during, or after a recession.
What are the consequences of reducing the percentage of risk assets (ie stocks, stock mutual funds, stock ETF’s, convertible bonds, junk bonds, etc.) if your money is invested more conservatively? That depends, of course, upon how investment markets do in the weeks, months, or perhaps years ahead. If the bull market we’ve been in since March 24th of 2020 still has legs, and the softening economic data and inversion turns out to be temporary and a false positive respectively, then investing more conservatively would likely lead to lesser gains for the remainder of the bull market. Is that an acceptable tradeoff? If, however, the bull market has already ended (at the end of last year) or comes to an end soon, then being more conservative would likely produce less volatility and lessen losses on paper during the period of decline. Would you prefer this? Finally, what if you’re the type of person that doesn’t worry about price fluctuation at all and you’re more interested, say, in the dividends and interest you’re receiving from these assets? Some investors are able to ignore price fluctuation completely in the belief that the correction or bear market will end eventually and prices are likely to recover to new highs as they have in every recovery on record.
Which type of investor are you? Each person has to answer this one for him or herself. Whatever your decision, I don’t believe anyone should take an all or nothing strategy. I wouldn’t invest completely in risk assets and I wouldn’t completely avoid them. If you haven’t already and you’d like to discuss this with me further to determine which of the above fits you best, please don’t hesitate to call me so that Patti and you can schedule this discussion with me. In the absence of any new discussion, I will do the best I can for you based upon my prior discussions with you.
Thanks for taking the time to read my thoughts and, as always, thank you for your trust and your business.
Brook R. Brook Menees, CFP®
Founding Partner – Financial Advisor
2013 - 2022 Five-Star Wealth Manager Recipient *
Click for more info: https://spotlight.fivestarprofessional.com/ereprints/367532
Instrumental Advisors, Inc. 10540 Marty Street, Ste. 210 Overland Park, KS 66212 (913)322-2100 Phone (913)322-2101 Fax
(913)243-2233 Text http://www.instrumentaladvisors.com
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All investing involves risk including loss of principal. No strategy assures success or protects against loss. Past performance is no guarantee of future results. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Government bonds and treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. All indices are unmanaged and may not be invested into directly. Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through V Wealth Advisors, LLC, a registered investment advisor and separate entity from LPL Financial. Instrumental Advisors, Inc. is also a separate entity from LPL Financial.
A quarterly newsletter written by Brook Menees, CFP®
September 2020: Wall Street vs. Main Street
And yet, the stock market as represented by the S&P 500 Index has not only recouped all of the losses from March (Covid) Madness but has gone on to reach a record high (up 46% from the March 23rd low as I write this and up 61% back on September 2nd). Does this make any sense? Have we seen new Coronavirus cases peak yet? No, it appears that, like many countries in Europe, we may be starting a second wave (or perhaps it is the second act of the first of multiple waves, God forbid). Do we have a proven, effective vaccine produced and distributed world-wide that will get us through the herd immunity period? No…not yet. We have over a hundred vaccine candidates worldwide but none have shown “proven and safe” results with large-scale (Phase III) human trials yet…we won’t have the first of these until Pfizer Corp.’s which we expect in the back half of October or beginning of November.
So why, then, is the market trading at such high levels both nominally and in relative terms historically? For example, according to the financial website AdvisorPerspectives.com, the S&P 500 stock index is prices in the top quartile over the last 100 years when considering price/trailing 12 months earnings, price/book value, price/sales, and price/cash flow. In my opinion, there are two significant reasons for this…government financial support (by both Congress & the Federal Reserve) and optimism. First, Congress has authorized up to $3.7 Trillion on various programs targeted toward getting the American people through this crisis. Secondly, the Federal Reserve has injected in the neighborhood of $2.3Trillion supporting the banks and the bond markets to make sure they continue to function properly (like greasing the gears of a machine). Historically, this encourages risk taking as the government’s actions are acting like a backstop with global participants in the US stock market assuming that government will step in if things get ugly. If the government doesn’t, of course, this assumption could backfire. However, so far they have.
Optimism is my second reason for the stock market trading at these high levels. I believe that many market participants are optimistic that one or more of the many vaccine candidates will “save the day” by significantly lowering the risk of hospitalization and/or death. Equally optimistic are the Wall Street economists and analysts who believe that earnings of American companies will rebound to pre-Covid levels (or better) justifying these elevated stock market prices. But what if they’re wrong? What if the best vaccine candidates which are expected to be in production within the next 6-8 months have too many negative side effects? What if the best candidates won’t be in production for 1-3 calendar quarters later? What if earnings take much longer to rebound than currently expected? This would make today’s prices look much more expensive if earnings stay lower for longer.
I encourage each of my clients to determine what percentage range for higher risk assets allows for swings in returns that they find acceptable. For example, one of my clients might be comfortable with a larger variation in their expected returns (say -20% to +20% in any calendar year) while another might be more comfortable with a smaller amount of variation (say -10% to +10%). Given the historically high valuations and vast amount of economic and political uncertainty (such as what rebound in earnings will we see and who will serve as our next President), might it make more sense to reduce risk by reducing the variability of possible outcomes? For example, the person who is normally comfortable with a 40% swing in results (-20% to +20%) could reduce their risk in hopes of producing a less uncertain rate of return (ie. -10% to +10%). One can generally accomplish this by lowering one’s stock market percentage, changing the mix of stock market investments to more defensive industries, changing the mix of stock market investments to other countries or parts of the world with lower valuations, lowering one’s higher risk bond exposure and/or raising one’s more conservative bonds, or perhaps best, a combination of these changes.
Let me give you an example. Let’s say my comfort level with the range of higher risk assets (stocks & above-average risk bonds) might normally be 40 – 60% which might have historically produced annualized returns between -15% to + 15% (a 30% annual swing potential). I might decide to reduce my risk assets to the lower end of my range (ie. 40%) thereby reducing my annual swing from a typical 30% to a typical 20% swing. This is the exercise I believe EVERYONE should go through right now. What range of higher risk assets fits your acceptable range of investment outcomes? I would then respectfully suggest that moving toward the lower end of your range, given the risks I perceive to currently exist, makes some sense. If however, you are one of those people who can ignore periods of higher market volatility, larger swings in investment returns, and have enough years before you’ll likely be taking distributions, then you may be able to tolerate staying at the upper end of your acceptable range of “riskier assets”. Remember that if a person doesn’t sell while prices are depressed, then their values only went down “on paper” because to experience an actual loss, one would have to sell while prices are lower than what he/she paid to acquire them.
Ultimately, there is no single answer that is appropriate for all investors. You need to determine what variability of investment outcomes you can handle. If you would like assistance in determining your range, I would be happy to assist you. In the meantime, please continue to be diligent about staying as safe as you can from this virus. So far, I have lost my Step-Father to it, my mother was in the ICU for six days but thankfully survived it, and I have lost one client to it (so far). It is real, it can be deadly, and it doesn’t belong to a political party. If it had a brain, I imagine it would hope that you might get a little too laxed and let your guard down, making you more vulnerable to contracting it. Please don’t let your guard down. Soon, we will all have the opportunity to take a vaccine or therapeutic which will lower our chances of landing in a hospital or dying from it. Please hang in there and stay vigilant….I remain optimistic that better days lie ahead. Let’s get there together, shall we?
May God bless you, your health, and the health of your friends and family! As always, thank you for your ongoing trust and your business.
Brook Menees, CFP®
2013 - 2021 Five-Star Wealth Manager Recipient *
Click for more info: https://www.fivestarprofessional.com/Spotlights/34812
Instrumental Advisors 10540 Marty Street, Ste. 210 Overland Park, KS 66212 (913)322-2100 (913)322-2101 FaxSecurities offered through LPL Financial, member FINRA/SIPC. Investment advisory services provided through V Wealth Management, a registered investment adviser. Mr. Menees conducts business through these two legal entities using the business name “Instrumental Advisors”. Instrumental Advisors, Inc., and V Wealth Management, LLC., are separate entities from LPL Financial.
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*Award based on 10 objective criteria associated with providing quality services to clients such as credentials, experience, and assets under management among other factors. Wealth managers do not pay a fee to be considered or placed on the final list of 2020 Five Star Wealth Managers.
The information provided here is for general information only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. Past performance is no guarantee of future results. Any economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Bond yields are subject to change. Certain call or special redemption features may exist which would impact yield. The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad, domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indices cannot be invested into directly.