So it’s official. The first bear market for the S&P 500 in two years and the third since the 2008 crash is upon us, leaving stocks at levels that Goldman Sachs says line up with 100% certainty of a full-fledged recession on the horizon.
Of course, mighty Goldman isn’t putting all its chips on a hard economic landing. Neither is the Fed. Right now, only Wells Fargo and Deutsche Bank are anywhere near that bearish, and I don’t think they’re really thinking everything through.
Yes, the Fed wants to slow the economy down. We’re shifting farther from boom times into slower waters. If the Fed slams the brake too hard, we end up in a stall. The distinction between that stall and a bona fide recession may be academic.
What If You Could Dodge Every Recession?
But while nobody likes to get stuck in a market that’s going over a cliff, history shows that a lot of investors bail out too early. Let’s do a thought experiment here.
Say I gave you a crystal ball that gives you perfect clarity on when the government’s economists call the top and bottom of the cycle. Like them, you can determine almost to the week when every recession begins and ends . . . you just see it in advance.
There’s one constraint. If you want to dump your stocks before the economy hits a rough patch, you have to be disciplined and set your sell orders the same amount of time ahead of every recession. It’s automated. When the crystal ball says a downturn is coming, you have to go. And you have to stay out until the recession is over.
How long do you hang on before you bail out? Do you wait until the last possible minute, practically the day the economy curdles? Or do you want to hit the exit months or even years ahead of everyone else?
I did the math. Going back to the 1960 recession, investors who hung on until the start of the month when the economic cycle peaked did the best. They captured as much of the upside as the crystal ball will allow, while avoiding all the stress and downside of owning stocks in a recession.
The earlier you pushed that “sell” button, the less upside you captured and the worse you did in the long term. In fact, investors who got nervous 18 months before the recession ended up with less money across the cycle than buy-and-hold types who simply gritted their teeth and rode the entire rollercoaster.
That’s where people who are pulling the plug on their portfolios ahead of what might be a late 2023 recession are now. You’re bailing out too early. Even if you have that infallible crystal ball on your side, the math is not your friend.
People who waited until a recession was only 12 months away ended up squeezing an average of 7% extra profit out of each economic cycle than those who took the 18 month exit. Waiting the extra 6 months paid off every single time . . . except for the 2020 COVID recession, which might be more of a hiccup than a real data point.
So if you have that crystal ball and know the economy’s twists and turns years in advance, I suggest waiting until the last possible minute to run for cover. Historically, stocks keep going up until the economic cliff is almost in sight. Why leave that money on the table?
Surprisingly Little Difference
Either way, I have to admit, selling the recession and buying the recovery doesn’t really generate a lot of extra profit in the long haul. Someone who bought the market on the brink of the 1960 recession and hung on for the intervening 62 years would have done extremely well over time . . . but the compound annualized return is only a little less than 7%, call it 6.95% a year.
The best “sell the recession” strategy I found, where you push the button in the very month the economy goes over the cliff, generates a long-term compound return of 7.7% a year. You’re gaining 0.7 percentage point.
Investors who waited a year before recession would have boosted their lifetime return to 7.05% a year. Congratulations. Your crystal ball earned you 0.10 percentage point compounded.
And those who decided they needed a full 18 months of lead time to get away from the downturn underperformed the buy-and-hold types by, let’s see, 0.38 percentage points a year . . . give or take a rounding error. They just missed out on too much of the good times.
Now I don’t really have a crystal ball. Neither do government economists, who always need at least a few months before they can even call the cycle end points in retrospect.
We rely on our guts. But as I’ve shown, investors who get nervous and swerve when they see a recession coming over the far horizon haven’t done appreciably better than those who stay on course until the last possible minute.
The market favors the bold, the tenacious and the courageous. Too much risk aversion can be as much of a drag as too little. If you’re not in the market, you can’t lose any money . . . but you can’t make all that much, either. We’re in the market to make money, not for shelter.
Of course, we all try to sit out the stormy periods. It’s human nature to try to maximize the good and minimize the bad.
But the market makes that difficult. We all need to take a little pain alongside the profit now and then. Recessions come and go. So do bear markets . . . remember, this is our third one since late 2018. We survived the others and came back smiling, didn’t we? Has the world changed in the meantime?
Not Every Recession Is “Great”
Your response to the crystal ball question reveals more about the ingrained emotional habits you picked up in past recessions than it does about the hard market logic of whether you should fold, hold or raise. For a lot of investors, the only recession worth remembering was the 2008 crash . . . the Great Recession, which left a generation traumatized.
Others remember the dot-com meltdown. A few were around for the 1990-1 recession or the rolling slowdowns of the early 1980s, but when you talk to investors who want to make sure they’re out of the market before the next one hits, they’re probably talking about a 2008-level event.
I wouldn’t have minded getting out of the market at the moment the 2007 boom ended. In retrospect, it even would have been nice to rotate into safety as much as 12 to 18 months before the recession officially started in December 2007.
But the Great Recession was so savage because it managed to be both a lot deeper and more prolonged than most downturns. The COVID recession of 2020, for example, was extremely savage but also extremely brief. Few investors are probably even considering it worthy of the name.
Compared to 2008, the dot-com crash was a blip on the long-term trend. Even the painful stagflationary grind that started the 1970s in such a somber mood didn’t produce that level of economic fallout . . . and either way, the Fed has proved that whatever it does, it won’t repeat past mistakes.
The Fed can learn. Powell and company bent over backward two years ago to avoid repeating the mistakes of 2008. No banks failed. Now, they’re probably studying the history of 2000 to do their best to avoid repeating Alan Greenspan’s hawkish program.
Sooner or later, the Fed always leaves the door open and the economy hits a new cliff. We might be on the brink of a bona fide recession. But until we know for sure, retreating into worst-case scenarios is usually as strong a recipe for disappointment as assuming that everything in life will go perfectly.
Life on Wall Street, as they know at Goldman Sachs, is all about percentages and probabilities. The glass is rarely full or empty, but your portfolio should be open to the shades (and shocks) in between.
Big stocks did badly this week. Smaller ones are showing early stages of recovering. It’s time for the stocks of the next generation to get a little spotlight.