Recession talk is dominating the news and investment commentary.
What should investors do?
Below are thoughts from our recent quarter end letter that may help.
The evidence about how markets have performed during these periods may surprise you.
As we wrote at about this time in mid-2020, intra-day market swings have been dominating the news and market commentary.
U.S. and global equity markets have dropped approximately 20% year-to-date, which essentially matches the large pullbacks we saw in the first quarter of 2020 and, before that, in the last quarter of 2018.
We start with this look in the rearview mirror to highlight that, even though the catalysts differ, market drops of 10-20% are reasonably common. As an example, the chart below illustrates that a correction (10% drop), bear market (20% drop), or recession (generally defined as two quarters of negative GDP growth) happens approximately every two years.
We are not mentioning this to dismiss or suggest that the drops in both equities and bonds aren’t significant – they are. As we have experienced in many other downturns, however, we are just staying mindful that market headlines can often make drops seem abnormal.
The Normal is that markets frequently go up and down in a manner that can be unnerving to everyone.
We wish we could confidently forecast what lies ahead for the market and the economy, but we have never met or heard of an investment professional who can. One of my favorite reminders of this comes from “A Spectacular Zero”, a research report written by a statistician a few years ago. The paper showed that Wall Street consensus estimates have historically had a 0% success rate in predicting a market downturn in advance.
Along these lines, much of the talk recently has been about Federal Reserve Board members and their forecasts, especially related to interest rates and the possibility of a recession.
Unfortunately, similar to Wall Street analysts, the predictive power of most past, and some still present, Federal Reserve governors also leaves much to be desired. As the chart below illustrates, with the exception of Janet Yellen, the overall accuracy of Fed Governor forecasts has been well below 50%, with the majority below 25%.
While no one can predict the future, what we can do is remain disciplined and stay focused on the evidence as to where opportunities may lie to produce attractive long-term returns.
As we just mentioned, even though few if any are successful at calling downturns before they happen, our experience in navigating past downturns is that when the word “recession” starts to seep into market discourse and is actually “called” by the government, it has consistently been a time to resist the negative news that follows.
To retest our thinking on this, we recently dove deeper into the performance of markets after a recession announcement. The chart below illustrates what we found.
Bottom line, the government body that calls recessions, the NBER, has consistently been late. The solid lines show the date of each trough announcement (the “calling” of a recession), atop a graph showing the total return of the S&P 500. Government calls have not been at the absolute bottom each time, but they are remarkably close, a degree of inaccuracy that the Fed has acknowledged in its market research:
“[Our forecast] errors were enormous in the severe recessions… and business cycle turning points.” – Federal Reserve – 1992
“The forecast did not anticipate the Great Recession that started in December 2007” – Federal Reserve – 2015
In quantifying the data, we found that, on average, if one were to have bought on the date the NBER announced that the economy was in a recession, the forward-looking 12-month return was north of 16%. Ironically, the converse has also been true. After the NBER has announced that a recession is over, a researcher that we collaborate with, Joachim Klement, found that the market has tended to drop slightly.
Based on this, we are staying focused on long-term trends – trends showing that, despite corrections, bear markets, and recessions about every two years, the S&P 500 has been positive approximately 80% of the time on a calendar year basis, producing an average annualized return of almost 13% (see the chart below updated through June 30, 2022).
With such high probabilities of high positive calendar year returns, even amongst dips, and such low probabilities of correctly calling a turn, even by the Federal Reserve, which receives data in advance of the market, we continue to stay anchored on our process of trimming positions if they have grown too large and buying if the market has taken portfolios too far out of balance with policy targets.
We will not always rebalance at the optimal moment, but by sticking to our process, we think we will remain in a good position to add value with reasonable levels of risk.