A year and a half ago, we wrote articles on how the economy could continue to grow for three more years and the stock market could increase 30% from March 2018. We based our stock market forecast on valuations, despite the fact that many thought stocks were already overvalued. The economic forecast was based on the anemic growth we’ve experienced during this business cycle, and suggested that the cycle wouldn’t end until the magnitude of growth at least reached the historical average. You can read these articles at the CFA Institute’s “Enterprising Investor” blog.
The stock market is halfway to our predicted target, and the economy has set a new record for the longest expansion so far. We continue to believe these trends will power ahead, but we’re also starting to think about what comes next.
We’re not economists nor market timers, but you don’t need a crystal ball to know that the good times can’t last forever. It also isn’t exactly controversial to say that a recession will likely hit within the next two years. What will that mean for investors?
In the near-term, it could mean significant incremental stock market gains. We’ve written in the past about how this market cycle feels an awful lot like what happened during the technology boom of the 1990s. The last few years of that cycle provided some of the best returns. Also, while we generally don’t give Presidents too much credit or blame for economic cycles, the current administration has a strong incentive to keep the good times rolling—at least until the next election.
Accordingly, it would not be surprising to see the Fed cave to pressure and lower short-term interest rates. Speculation of the Fed’s next move has whipsawed markets recently, indicating we could see further gains if the Fed ultimately eases policy. A trade deal with China would also likely move stocks higher.
A recent theory from a noted economist posited that President Donald Trump would work to force down interest rates through verbal pressure and by weakening the economy with incremental tariffs. This would cause the Fed to lower interest rates, and then just before the election the President would eliminate all tariffs. There is no way to know if this is the actual plan, but it certainly could keep the economy and stock markets moving higher for a while.
Even if that were to occur, such moves likely won’t make for a lasting expansion. We need to recognize that a downturn is looming, even if it is a couple years out.
There are signs already. Growth in capital spending by corporations is slowing down; corporate earnings estimates are being drastically cut; credit card interest rates have risen to their highest levels in at least a couple decades, which could pressure consumer spending; and while the headline jobs figures still look robust, deeper in the report are signs that large corporations are cutting back on hiring. The situation is worse overseas, with flattish economic growth and negative interest rates in some countries. The New York Fed maintains a recession-probability model that has been rising and is now at levels seen just before past recessions. The indicator has only once been this high without a recession occurring within two years.
Keep in mind that recessions do not mean the sky is falling. There are mild recessions, like the one around the Gulf War in 1991, and there are deep recessions like the one that started in 2008. Other than the Great Depression, which lasted three and a half years, the longest recession since 1926 lasted eighteen months. So, recessions tend to be fairly short lived, and our economy is strong and flexible enough that it has always rebounded and gone on the reach new peaks.
The stock market drawdown during recessions has often been quite modest, with dips of 15% or less in many cases.
However, there are also the more memorable declines of 50% or so such as in 2008, during the technology bust of the early 2000s, and previously in the early 1970s.
No one knows for sure what the next recession will hold in store, but we suspect the impact to the stock market will be more severe than the milder cases, after all, the stock market dropped almost 15% in the last quarter of 2018 alone with no significant economic event. That doesn’t mean that we’ll see another crisis like in 2008, just that a higher level of volatility is likely coming.
We have all lived through these periods before, and they are not a reason to disrupt long-term investment and financial plans. There are actually some benefits. They can offer an opportunity to avoid taxes through disciplined loss harvesting that can be carried into the future. And they can allow us to reposition portfolios that may need adjustments that we’ve been putting off to avoid tax problems.
For those still saving money, market downturns offer an opportunity to buy stocks on the cheap. For those not saving, we will be rebalancing from bonds to stocks as stocks drop in price. This creates greater leverage when stocks ultimately recover.
That is not say that we’re looking forward to the next recession or bear market. It is merely an acceptance that downcycles are part of investing. We’ll live through it as we have in the past.
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