Should you sell your stocks? – Predicting the next recession

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An impending recession?

Recently there has been a decent downswing in the US stock market and stock markets globally. Generally, when a big sell-off like this occurs, it sparks investor panic and causes many pundits and market participants to begin speculating on the state of the economy and question whether we may be on the precipice of another major bear market…

I’ve decided to put my two cents in and voice my own commentary of the current situation based some research and experience. Given that this kind of speculation arises periodically I’m thinking of making this a regular piece to do about once per year or more frequently if market conditions warrant it.

The goal with market timing

What would you say if I told you that next week the stock market will rise?  The first thing you’d probably ask me is how I could possibly know this would be the case – especially given the enormous number of factors affecting the market. If you saw my track record and it supported that I had accurately predicted weekly falls and rises with a high strike rate then you’d probably give me the benefit of the doubt. There’s many traders touting themselves as market sages who claim the ability to predict the market like this. Most are dishonest and are merely seeking attention. Some have more sinister motives and are out to market some rubbish product which doesn’t work. Some may have enjoyed short term variance, which has been running in their favour. The fact of the matter is that those who can anticipate the market in such a fashion and have the record to back it up are as rare as hen’s teeth. However, I’m going to stop short of dismissing their existence altogether!

What I’m trying to allude to is that it’s much easier to sit back and look at the big picture when we talk about the financial markets. The stock market moves according to economic cycles and had done so, ever since it’s inception. When growth is declining and the economy contracts the stock market usually falls prior to this. It’s much easier to look at the collective body of evidence from economic indicators such as employment figures, yields in the bond markets and what the central bank are saying and then make a call about what will probably happen to the stock market.

When we start to look in terms of weeks or shorter periods, the market movements become less related to the overall cycles and follow a much more random pattern. Timing the market at this level is extremely difficult – we are far better just trying to focus of timing the market according to the economic cycles instead. Or arguably not timing the market at all – and instead relying on a simple buy and hold approach, which often wins out compared to other strategies anyway.

Crystal balls

There are many ways of looking at the market and trying to interpret what will eventuate in the future. I prefer to take a long-term approach and look at the fundamental reasons and economic indicators, while other people may prefer to take a technician’s approach and look for patterns in charts or moving averages. Perhaps the most well-known and touted of the economic indicators which is correlated to recessions, is the spread between yields on short term US bond yields and long-term bond yields. The typical being the 10 year minus 2 year, but there is some research to indicate that the 10 year minus the 3 month is a better candidate. This is definitely a favourite indicator of mine too. It has a fantastic track record evidenced over decades and successfully ‘predicted’ the last two recessions. In a normal state the short-term bonds should earn less interest than those with a longer maturity. Prior to recessions the short-term bonds have actually had higher yields than the long bonds. You may wonder why anyone would ask for less to hold debt for a longer period of time and the answer has to do with inflation expectations. Investors anticipate lower inflation in the future and so long-term bonds become popular and their price goes up and the yield moves down.  As you can see from the following chart, generally when the difference became negative, a stock market collapse followed and a recession (shaded grey) shortly followed that. Since the yields for various maturities are generally plotted on a graph called a yield curve, this type of situation is referred to as an inverted yield curve.

yield curve.png

Some people argue that the yield curve has been distorted due to the affects of quantitative easing and it is now more prone to inversion- deteriorating the predictive power of an inverted yield curve. This is actually a fairly reasonable argument to make since this had never occurred previously and was considered an extraordinary measure. Some also criticise the small sample size. Although these are both valid arguments and may indeed affect its predictive power, it should at least raise questions for investors and make them consider their market position if an inversion occurs.

Following the Federal Reserve

graph of interests.png

Another powerful indicator, is the Federal Funds rate (FFR). Over the last 20 year, the FFR has moved in rather neat cycles of gradually increasing to plateau and then steeply declining to another plateau. When the FFR has declined sharply in a short time after an interest rate hiking cycle it is a strong indicator that things are about to go pear-shaped and has accompanied a stock market collapse. Really the FFR is in a way, just about the ultimate indicator – the Central Banks’ board is a group of experienced economists who look right across the local and the global economy when making an assessment and determining what to set the interest rate.

Why I’m not selling my stocks …. Yet

There are many other popular indicators for recession timing – a couple that are worth mentioning are VIX & P/E ratios. Considering that the Federal Reserve only recently hiked the interest rates and has signalled the intention to raise them next year, they’re sending a clear message to the market that as far as they’re concerned the economy is strong and the signals are good – it’s full steam ahead. On the other hand, the yield curve is flattening but is still yet to invert and historically the stock market was a good ½ year + off it’s top after an inversion happened anyway.

To me at this stage, this is just another sell-off.

After reaching an all-time peak of 2940 in September, 2018 it has now fallen to 2467 as of the time of writing this. This represents a 16% decline from the all-time peak, which is a reasonable sized pull-back from the overall uptrend that the market has been on since 2009. It’s worth noting that back in 2015-2016 there was a considerable decline of around the same 13%. And in 2011 there was a decline of around 17% from the high. Although declines of 10+% don’t occur to often during bull markets, it’s happened twice in the last 10 years and the market grew considerably thereafter. Although the recent drop is somewhat sizeable and concerning, I’m going to (perhaps naively) trust the historically reliable indicators mentioned earlier and bet it is more than likely just an unpleasant sell-off.  Ups and downs are a part of the market and we have just seen an incredible run of growth in stock prices, which has only recently been tainted by a steep correction. The best course of action is to just take advantage of the low stock prices through any way possible. Without having much idea of how much the market will fall, I think it would be wisest to let price consolidate somewhat before buying the dip. If the idea of losing a lot of money recently on your stocks depresses you – just think – right now stocks are on sale at a discount of 16% from a two months ago! Not only that, but right now, dividend yields are much higher. I’m staying positive and I accept that the markets change quickly and stocks are a long game…

 

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