The word recession
has been hanging over the markets like the Sword of Damocles. However, for the better part of a year, investors had only been hearing rumors of a recession. Then, in August, they saw a visual indicator that has been a (somewhat) accurate predictor of a recession, the inverted yield curve.
The classic definition of an inverted yield curve occurs when the yield on a 10-year Treasury bond falls below the yield of a 2-year bond. In reality, parts of the yield curve can and do, invert with some regularity. However, the 2/10 inversion is one that economists have found to be a reasonably accurate predictor of a coming recession. The reasoning is easy to understand:
- Bond investors expect to be compensated with a higher yield for locking up their money for a long period of time. The same principle applies to fixed-income instruments like certificates of deposit (CDs).
- Bond prices and bond yields have an inverse relationship. When one goes up, the other goes down and vice versa. Price movement in the bond market is subject to the basic economics of supply and demand.
- Bond prices go down (and yields go up) when there is less demand for those instruments.
- When long-term bonds yields go down it suggests that investors are buying more long-term bonds, therefore moving the price of those bonds up and the yields down.
With that explanation aside, let’s consider what a recession really means for your portfolio. To begin with, economists don’t have a consensus about when, or if, a recession will arrive. Most are saying that the economy could be in a recession within 18 months. But that’s a long time from today. And, the thing about a recession is that it’s a lagging indicator. In other words, the economy could be in a recession for a few months before a recession is officially declared.
The real question for investors to ask is how are you feeling about your portfolio today? Are the volatile market swings causing you to rethink your investment strategy? Are you thinking that it’s time to move some money out of equities, but you’re coming down with a case of FOMO (fear of missing out)? If so, it’s time to take a deep breath and take a realistic look at your portfolio.
As 2019 winds down, here are concrete actions you can take to protect your portfolio for whatever is in store for it in 2020.
First, the base of every investing pyramid is cash. Regardless of your age, you should take a look at your current employment situation. Are you in a cyclical industry that may be affected by a recession? Is your company in a financially solid place? What would your realistic prospects be to find a new job if you were to be displaced? Would that require relocation?
My point is not to get all into the personal finance side of things. But if you believe a recession is coming, it may be time to pull some money out of the market to ensure that your emergency fund is amply supplied. In a recession, markets tend to decline. You don’t want to have to sell equities at a time when prices are dropping (selling low). This may mean having six, nine or even a full year of salary readily available to use depending on your age.
Ok, enough of that unpleasantness. Once you take care of your base, where should you look to invest? If you’re a younger investor, you may not have to do too much, and you still want to be focused on growth. Time is on your side and over time equities (such as stocks) will outperform debt instruments (like bonds) or cash. However, a recession can make it difficult to pick winners and losers. This may be a time to move from individual equities into mutual funds or ETFs that allow you to invest in a basket of growth stocks. You manage risk, but still, maximize your opportunity for growth.
For middle-aged investors, it’s time to start remembering that defense wins championships. You may want to keep pushing the needle. But consider what happened to cryptocurrencies at the end of 2018. There was a rush of investors who were buying bitcoin and other digital currencies and lost a lot of money. Do you still want to be on the tech roller coaster? Now is not the time for that. Your primary goal is to see where you’re at relative to your larger goals. See that money that you need for a child’s college fund? Get it parked somewhere safe. How about the money in your retirement account? You might have a little time, but now is the time to start shifting to a more value-investing approach. It may be time to get out of the riskier sectors (like technology) and into what are considered defensive sectors (health care, consumer durables, etc.). These are products that consumers will still need regardless of the market. This may also be a good time to start buying high-quality dividend stocks.
For retirees, you’re not off the hook. While it’s true that you’ve probably reduced your exposure to equities (your primary goal, after all, is capital preservation), it’s important that you still look for some growth. High-quality dividend stocks tend to hold their value and provide a modest amount of growth, regardless of the market conditions. And just as we outlined above, you may even need to consider pulling more cash out of your portfolio now to ensure that you’re tapping retirement savings that are designed to last 20 years or even more.
The bottom line for investors regarding a possible recession is not to panic. Recessions are a normal part of a business cycle. Many investors are justifiably spooked because of the intensity of the last recession. But making emotional investment decisions rarely works out well. The end of the year is a good opportunity to look at your investing goals and make any adjustments that will better prepare you for success regardless of what happens to the markets.