The debate is over. We have an inverted yield curve in fixed-income securities, where short–term rates are higher than long–term rates. Consumers are stretched thin, battered by the twin spectres of rising interest rates and higher-than-average inflation. The days of cheap money are over, and the real estate market continues to soften. Taken together, all of these indicators almost certainly point to one thing, and one thing only: we’re either close to, or already in, a recession.
So given that the next year will likely bring with it a recession of unknown depth and duration, how could anyone in their right mind possibly think that continuing to hold onto stocks is still a good idea? The reason is simple, and it has to do with two of the most popular – and most frequently mistaken – investment myths. The first is that recessions offer a reliable way for investors to time when to enter and exit the stock market. The second is that, during a recession, the markets always go down.
Let’s start with the myth that recessions always lead to a decline in the stock market. There’s no question that the markets don’t like recessionary conditions. But the problem we face as investors is that the markets tend to react to things like recessions long before they actually happen.
Historically, the stock market has almost always priced in the impact of most recessions well in advance of when those recessions finally arrived. The same is true for the inevitable recoveries. From an investment standpoint, this means that by the time we find out that we’re in or on the brink of a recession, the worst could already be over. Since no one really knows when the precise beginning or end of a recession will occur until it’s in our rear-view mirror, trying to predict the exact best time to sell stocks or buy them back becomes extremely challenging – if not outright impossible.
Just consider this fictional, but very well-researched, example. In his excellent book, The Psychology of Money: Timeless lessons on wealth, greed, and happiness, award-winning author Morgan Housel profiled three imaginary (and very long-lived) investors to make a point about the potentially disastrous impact of trying to time the markets in response to a recession.
The first hypothetical investor, Sue, puts one dollar a month into stocks each and every month between 1900 and 2019 without fail, regardless of whether the markets are up, down or sideways.
Jim, the second investor, puts the same one dollar a month into the market every month, except for those months when there is a recession. With fortune teller-like accuracy, he stops investing at the exact start of each recession, saves the cash he would’ve otherwise invested for as long as the recession lasts, and then puts all that saved-up cash back into the market as soon as each recession ends. Then he goes back to his regular dollar-a-month investment schedule until the next recession.
Finally, our third investor, Tom, stops investing six months into a recession, and holds off for another six months after the recession ends. At that point, he puts all his accumulated cash back into the market, and resumes investing one dollar a month for all the other months going forward.
With such extraordinarily precise timing to compete against, you’d think that Sue, with her foolishly naïve consistency, would end up dead last. But in fact, the intrepidly steady Sue actually comes out way ahead of her market-timing rivals, with her portfolio at the end of 2019 valued at a whopping $435,551. Jim, with his seemingly perfect instinct for timing, comes in a distant second at $257,386. Finally, the recession-phobic Tom pulls up the rear, with his portfolio ending 2019 worth just $234,476.
This 119-year comparison sends a pretty convincing arrow right through the heart of our two investment myths. There’s no question that stock markets do sometimes decline throughout a recession. But as our example illustrates, they also often don’t.
In the last six recessions, the S&P 500 index averaged a surprisingly solid compounded return of around 9.5 per cent. The problem with using recessions as an indicator of whether or not to own stocks is that some of the best market days of our investment lives will actually occur during a recession – just as some of the worst days for investors will happen long before a recession officially begins.
So before you decide to follow the dire forecasts favoured by the clickbait set and cash in everything you own, it might be worth remembering what the Oracle of Omaha, Warren Buffett, once famously said: “The risks of being out of the game are huge compared to the risks of being in it.” If you ask me, those words are just as true today as they have been for every other up- and down–swing in the history of the markets.
This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.