Is the recession finally here?
Roughly two years ago, economists predicted what they called the most widely anticipated recession ever. The whole world seemed to be holding its breath and bracing for the worst.
But we got lucky. The stock market shrugged it off, and the recession never happened.
Then early last year, many experts, including us, warned of dangerous imbalances in the economy and stock market.
Again, our collective luck kicked in, and the stock market went on to make new all-time highs.
Now, we’ve just experienced a nasty stock market drawdown that impacted markets worldwide. Japan fell by (and then mainly recovered) 25%, and our home markets (including the DOW, tech-heavy NASDAQ, and small-cap Russell 2000 indices) have been uncharacteristically volatile.
Has our luck run out?
And if it has, how can you protect your investments in this potential market downturn?
Factors affecting a potential recession
If the recession is finally here, you can prepare to protect your investments by understanding some of the factors at play.
Economic Slowdown
Despite warnings over the past couple of years, healthy employment rates, consumer spending, and government funds have kept the economy moving.
Not even last year’s technology sector layoffs were enough to derail GDP (gross domestic product) growth.
But since then, new signs of trouble have emerged, including
–A general hiring slowdown,
–Layoff announcements in industries other than tech,
–Weak corporate earnings reports, and
–A realization that the Fed either won’t bail us out with interest rate cuts or that it’ll be too late if it does.
An inverted yield curve (occurring when interest rates on short-term bonds exceed those of long-term bonds) started roughly two years ago. Historically, inverted yield curves have been precursors of recessions with uncanny reliability.
Between that and the Sahm Rule (an economic indicator that triggers when the 3-month average national employment rate rises by >0.50 percentage points relative to the low of the previous 12 months), it seems we may already be in a recession.
But we knew this would happen, even without economist warnings.
General common sense would tell you that the economy can’t continue this way forever.
Especially because governments around the world have been printing and spending money like drunken sailors since Covid.
In other words, the government has overspent on its ‘credit card.’ If you or I do that, we need to spend less and pay up.
And while it’s unlikely the government will ever pay off its debts, spending does need to slow down.
One estimate suggests that interest alone on federal debt will reach $2 trillion next year. That’s real money when the total GDP is $20-25 trillion (depending on seasonal adjustments and other factors).
More importantly, it’s real money that can’t be spent on other, more productive, economy-boosting uses.
A market downturn triggered by a recession wouldn’t be a surprise in this environment.
Elevated market valuations
Making matters worse is that stock market valuations have been over-inflated.
In fact, the growth of some of the biggest and most popular technology stocks has driven virtually all of the stock market’s rise over the past couple of years.
They’ve also driven valuation ratios like the price-to-earnings (P/E) ratio to levels we haven’t seen since 1929 and 1999, right before major market downturns hit.
Other parts of the market, including stocks from smaller companies and international markets, have stayed more reasonable, but overall, the market has gotten too lofty.
Data from Nobel Laureate and Yale professor Robert Shiller shows that the stock market is still quite high compared to past valuation levels.
Shiller uses a tool called the CAPE ratio to determine whether the stock market is priced fairly. The CAPE ratio looks at how much stocks cost compared to how much money those companies actually make, and it does this over a longer period of time to avoid getting distracted by short-term ups and downs.
Right now, the CAPE ratio is almost as high as it was during the Dot Com Boom. If the stock market were to return to a more “normal level” based on the CAPE ratio, prices would need to drop by about 50%.
But this may not be a fair analysis since Shiller’s data goes all the way back to 1871, and the economy has changed a lot since then.
If we start from a more modern date and randomly choose 1980, the market is still about 30% overvalued. This means that if the market corrects itself, we could see prices fall by 30% or even more if things get really bad.
Historically, in the worst stock market downturns since the Great Depression, stocks have dropped by a little more than 50%.
While a drop that big would only happen in a major crisis, it’s not out of the question.
Political and Geopolitical issues
We’re currently facing two wars, with at least one having the potential to spiral out of control.
Wars have generally been “good” for the economy and stock market, but they also create a lot of uncertainty that leads to short-term volatility.
And it seems our leaders aren’t even paying attention – either because they’re unable to focus or have been too focused on election season.
But the choice of our next president may really matter this time around.
In the past, it often didn’t matter who was in the White House. Stocks marched higher regardless of the party in control.
Though both parties and their current candidates have a history of encouraging large amounts of spending at the federal level, there are vast differences in policy to consider.
The big differences include Kamala Harris wanting further regulation and taxes on corporations, which will likely impair corporate earnings. More recently, she has been talking about price caps and higher capital gains taxes.
Donald Trump is talking about a large increase in tariffs, which have not always been stimulative when enacted historically (I’m looking at you, Smoot-Hawley).
So, both candidates are discussing policies that appear to be inflationary, but the full impact of their policies on economic growth and the stock market could be quite different.
Speaking of inflation, while prices have leveled off from last year, we probably haven’t heard the last of it.
If the Fed cuts interest rates to head off a recession, we could see prices spike again.
And, if our next president continues the current fiscal policy of spending like mad, we could see a period of stagflation (characterized by stagnant economic growth, high unemployment, and persistent inflation) like we experienced in the 1970s.
We certainly hope there are solid economic advisors in the next cabinet.
Actions to protect your portfolio in a market downturn
All of this paints a fairly gloomy picture, but unfortunately, we feel it’s warranted.
So, what are the implications for portfolios? And how do you protect your investments in a market downturn?
Well, the best advice here is to buckle up.
It’s probably going to be a bumpy ride for a while, but that doesn’t mean the sky is falling and all hope is lost.
We’ve been through these periods before, and our American work ethic and perseverance have always helped us get through to brighter days.
Even during a severe recession, most companies stay in business, and most people keep their jobs, which helps keep the economy going until the trouble passes.
Whenever the downturn finally arrives, there are a few time-tested actions you can take to prevent undue portfolio damage.
Note: Selling out of stocks is generally not the best approach.
Diversification
The time has come to prioritize smart portfolio management.
While you might have been better off putting all your money into tech stocks in the past, that’s likely not the best idea going forward.
As mentioned above, valuations for other parts of the stock market are much more attractive than for the tech sector. We expect those stocks to hold up better and outperform in the ultimate economic recovery.
Other investments, like bonds, can also help diversify and hedge stock market downturns.
Bonds have been much maligned over the past several years, often by us, because they haven’t provided much in the way of return for the better part of a decade. But they do offer a safe port in a storm. Having some “boring” bonds in the portfolio is probably a good idea for most investors, especially those nervous about stock market downturns.
We also like some liquid “alternative investments” that historically have held up relatively well during stock selloffs, but we have to be quite selective about this strategy.
Tax Loss Harvesting
If a stock market decline really heats up, we’ll be looking for opportunities to realize tax losses.
We do this by selling a stock when it goes down and immediately reinvesting in something similar.
This keeps your portfolio exposures in place but realizes a loss that can be used at tax time to offset capital gains. It’s a very efficient way to reduce your tax bill this year if you’ve realized capital gains in the first half of the year or sold a business or investment property.
You can also use this strategy to help offset taxes in the future since realized tax losses carry forward forever – which is why we aggressively realize losses even if clients aren’t facing a big tax bill this year.
Rebalancing
We also look to rebalance during downturns.
While it may sound counterintuitive, we like to buy stocks as they fall because it helps establish bargain-priced positions when stocks are “on sale.”
It also helps in the ultimate recovery since the stock exposure will be greater at the bottom of the downturn and can earn outsized returns when the rebound arrives.
Historically, the best returns for stocks come during recoveries off crisis period lows.
So, a market downturn is the right time to rebalance your portfolio.
Look for opportunity in a potential market downturn
No one’s excited to face an economic recession or stock market downturn, but they’re a part of life.
And while uncomfortable, they don’t have to be life-changing events.
When managed properly, you can protect your portfolio and get through with minimal long-term damage, often even if you’re drawing funds from your investments to live on.
Whether the current volatility is just a blip or devolves into a recession, bear market (a period where the prices of securities experience a significant and prolonged decline of 20% or more from recent highs), or even a financial crisis, it pays to look for opportunities to optimize your investments.
Handled properly, downturns can be a time of opportunity rather than despair.
Need help taking action on your portfolio ahead of the potential market downturn? Get in touch with our registered investment advisors for a complimentary consultation.
**Notice:
Armbruster Capital Management’s views, as portrayed in this post, are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Investing involves risks, and the value of your investment will fluctuate over time, and you may gain or lose money.
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