Denver Business Journal: Dana Gleason Nightingale, CFA, on recessions and best ways to prepare for down markets

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Lately, many clients have been asking, “Are we entering the next recession?” Given the current market environment and news cycle, the fact this is top of mind is no surprise. The China-U.S. trade war has dragged on for over a year. The U.K. seems set on leaving the European Union, and negotiations on the mechanics of that separation have been messy.

Charged political headlines seem to be front and center as the U.S. approaches an election year. To top it off, the yield curve temporarily inverted earlier this year, an economic phenomenon that many pundits believe is a reliable indicator of an impending economic downturn.

Recessions are complicated and give even the most sure-footed investor anxiety. What exactly is a recession? A recession occurs when individuals and businesses spend less, usually out of fear or uncertainty, causing a temporary economic decline. It is generally identified by a fall in gross domestic product (GDP) for two consecutive quarters. Recessions are caused by an imbalance, such as excessive debt or overvalued assets, that ultimately needs to be corrected and can lead to a drastic price decline in assets. For example, tech shares lost as much as 80% of their value when the dot-com bubble burst and largely contributed to the recession in 2000–2001.

When most people think of recessions, they flash back to 2008. Clients have a visceral reaction when the topic comes up, recalling the impact of this painful period. The behavioral finance concept known as “recency bias” says that we ascribe more value to recent events and less weight to earlier ones. The Great Recession was the most extended and severe recession since the Great Depression of the 1930s. Most recessions are far shorter and less painful, lasting less than a year and affecting a narrower set of assets. [1]

For long-term investors, a recession should be a blip in a decade or more of growth. Many clients also want to know how their portfolios will be affected by the next recession. One frequent misconception is that the stock market always declines during a recession. In six of the 12 recessions since World War II, stocks actually gained from beginning to end. During three of those recessions, stocks achieved double-digit returns. If we expand the time period to include the six months after a recession’s end, stocks gained in all but three instances and returned an average of 10%.

In contrast, stocks experience their most substantial declines leading up to recessions. The market drops, on average, 8% from its peak to the beginning of the recession and recovers before the broader economy does. [2] In sum, economic growth lags stock performance, making it nearly impossible to enter or exit the market with any confidence by reading the signals. Most investors who try to do this – a practice known as “timing the market” – miss out on upside when they are overly focused on where we are in the economic cycle.

So, how does one prepare for a recession? We recommend focusing on the long-term drivers of growth and confirming with your financial professional that your asset allocation contains the right mix of stocks and bonds. While an all-stock portfolio may provide the highest average returns, it also exhibits the most considerable declines during periods of fear and uncertainty. Adding bonds and other non-correlated assets to your portfolio gives you the stability to stay invested and make distributions if needed even when stocks decline. If you have concerns about the market, your portfolio, or a potential recession, reach out to your financial professional to discuss. It is their job to worry about and manage the risks so that you don’t have to.

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[1] The National Bureau of Economic Research, U.S. Business Cycle Expansions and Contractions; refers to recessions in the post-World War II era.

[2] Bloomberg data