Is it finally here? Roughly two years ago economists predicted what was being called the most widely anticipated recession ever. The stock market shrugged it off and the recession never materialized. Early last year, we and many others warned of imbalances within the economy and the stock market that appeared to be in dangerous territory. The stock market went on to make new all-time highs. Are the chickens finally coming home to roost?
Early August was an ugly period for the stock market. The Dow Jones Industrial Average had shed roughly 1,500 points, and things looked pretty bad for a few days. That correction ended up being short lived.
Things were worse in other markets. The tech-heavy NASDAQ Composite index, the small-cap Russell 2000 index, and some overseas markets fared much worse than the Dow. At one point, Japan’s Nikkei 225 index had fallen around 25% from its recent high.
Diverse markets, such as commodities, foreign exchange, and even cryptocurrencies took a beating. What’s happening? Well, there are a confluence of factors.
Economic Slowdown
First, and most importantly, is the economy. Despite warning signs over the past couple of years, robust employment, consumer spending, and government largesse have kept the economy moving in the right direction. Even layoffs in the technology sector a year ago didn’t seem to derail GDP growth. However, additional signs of trouble have emerged, including a general slowdown in hiring, layoff announcements in industries other than tech, weakness from the manufacturing sector, a realization that the Fed either is not going to bail us out with interest rate cuts or that it will be too late once it does, and weakness in recent corporate earnings reports.
An inverted yield curve that started roughly two years ago portended the slowdown. A recent indicator, the Sahm Rule, suggests we may already be in a recession. However, general common sense also indicated that the economy couldn’t keep on forever. Governments around the world have been printing and spending money like drunken sailors since Covid. It doesn’t take an economist to know that you can’t do that forever. If you overspend on your credit card, eventually you have to pay up.
That means spending less while you pay off your debts. The government will likely never pay off its debts, but spending does need to slow down when debt gets ahead of itself.
One estimate shows that interest expense on our federal debt will come to $2 trillion next year. In an economy where total GDP is around $20 to $25 trillion (it depends on seasonal adjustments and such), that’s real money. More importantly, that’s money that can’t be spent for other more productive uses that can drive the economy forward. A recession in such an environment would not be a surprise.
Valuations
Making matters worse is that stock market valuations have been elevated. Indeed, that is likely why the NASDAQ fell more than the Dow or the S&P 500. The tech-heavy NASDAQ has benefitted the most from the rise of the “Magnificent Seven” stocks that have come to dominate the market. The largest, growthiest technology stocks have driven virtually all of the stock market’s rise over the past couple of years. They have also driven valuation ratios, like the price-to-earnings (P/E) ratio to historically high levels. Those levels were on par with levels just before major downturns in the past, like 1929 and 1999.
Other market segments, such as value stocks, smaller-cap stocks, and many international markets have traded at much more reasonable levels, but the overall market has been lofty and subject to a correction.
Data from Nobel Laureate and Yale professor Robert Shiller show that the stock market is still quite high compared with past valuation levels. Shiller uses something called the CAPE ratio which is sort of a long-term P/E ratio that smooths out short-term fluctuations in corporate earnings. The CAPE ratio until recently was the second highest reading on record, behind only the Dot Com Boom. The market would need to fall by 50% to get to the long-term average CAPE level. However, that probably isn’t a fair analysis since the CAPE data goes back to 1871, and the world and economy were very different for much of that period.
If we look at a more modern average from 1980 (a date picked at random), the market today is still 30% overvalued. It would not be surprising to see a 30% correction, or even more if things really get nasty. In the worst stock market downturns since the Great Depression, stocks have generally fallen a little over 50% from their highs. It would take a full-blown crisis for that to happen, but unfortunately, that is not out of the question.
Politics/Geopolitical
We are currently facing two wars, at least one of which seems to be heating up and has the potential to spiral out of control. Compounding the trouble is that our leaders aren’t necessarily paying attention. They either are not able to focus, or they are focused on the last few months of election season. Wars have generally been good for the economy and stock market, but they also create a lot of uncertainty that can result in short-term volatility.
The choice of who becomes our next president could be material this time around. In the past, it often hasn’t mattered who was in the White House, as stocks marched higher regardless of which party was in control. It may be a little different this time because of the vast differences in policy. Although both parties and both current candidates have a history of encouraging large amounts of spending at the federal level.
The big differences include Kamala Harris wanting further regulation and taxes on corporations, which will likely impair corporate earnings. However, Donald Trump is talking about a large increase in tariffs, which have not always been stimulative when enacted historically (we are looking at you Smoot-Hawley). Both candidates are discussing policies that appear to be inflationary.
Speaking of inflation, while price growth has abated from the runaway level of last year, we don’t believe we’ve heard the last of inflation. If the Fed cuts interest rates to head off a recession, we could see prices spike again. And, if our next president continues the current fiscal policy of spending like mad, we could see a period of stagflation like we experienced in the 1970s. We hope there are solid economic advisors in the next cabinet.
All of this paints a fairly gloomy picture, which we believe is warranted. What are the implications for portfolios? Well, the best advice here is to buckle up. It will probably be a bumpy ride for a while. That doesn’t mean the sky is falling and all hope is lost. We’ve been through these periods before, and the work ethic and perseverance of the American workforce has always helped us get through to brighter days. Even during a severe recession, most companies stay in business, most people keep their jobs, and that helps keep the economy going until the trouble passes.
The actions we take to get through the downturn without undue portfolio damage include diversification, tax loss harvesting, and rebalancing. We’ll be looking for those opportunities if this downturn persists.
Diversification
While a diversified portfolio has been a liability the past couple of years, we believe the time has come for smart portfolio management. In the past you would have been better off just putting all your money into tech stocks, but probably that won’t be the best idea going forward.
As mentioned above, valuations for other parts of the stock market are much more attractive than for the tech sector. We expect those stocks to hold up better and outperform in the ultimate economic recovery. We build diversified portfolios across all the sectors of the stock market, and that should offer a buffer in any downturn that materializes.
Bonds have also been maligned the past several years. Bonds have not provided much in the way of return for the better part of a decade, but they do offer a safe port in a storm.
We also expect our alternative investments to hold up relatively well in the face of a stock market downturn. However, selectivity is key in this sector.
Tax Loss Harvesting
If a stock market decline really heats up, we’ll be looking for opportunities to realize tax losses. That means selling a stock when it goes down, and immediately reinvesting in something similar. That keeps your portfolio exposures in place but realizes a loss that can be used at tax time to offset capital gains. This is a very efficient way to reduce your capital gains tax bills either this year (if you have realized gains in the first half of the year or sold a business or investment property) or can help offset taxes in the future since realized losses carry forward forever. That is why we aggressively realize losses even if you aren’t facing a big tax bill this year.
Rebalancing
We also look to rebalance during downturns. While it may sound counterintuitive, we like to buy stocks as they are falling. It helps establish positions at bargain prices when stocks are “on sale.” It also helps in the ultimate recovery since you’ll have more exposure to stocks at the bottom of the downturn that can earn outsized returns when they start to rise. Historically the best returns for stocks come during recoveries off crisis period lows.
No one likes economic recessions and stock market downturns, but they are part of life. While uncomfortable, they don’t have to be life-changing events. If managed properly, we can get through with minimal long-term damage, often even if you are drawing funds from your investments to live on. Whether the current volatility is just a blip or devolves into a recession, bear market, or even a financial crisis, we’re here looking for opportunities to optimize your investments. Don’t hesitate to reach out if you are nervous or would like to talk through your portfolio in more detail.
No one likes economic recessions and stock market downturns, but they are part of life. While uncomfortable, they don’t have to be life-changing events. If managed properly, you can get through with minimal long-term damage, even if you are drawing funds from your investments to live on. Whether the current volatility is just a blip or devolves into a recession, bear market, or even a financial crisis, it pays to look for opportunities to optimize your investments. Handled properly, downturns can be a time of opportunity, rather than despair.