- Ignore economists
- Size your investments properly
- Don’t time the markets
Stock and bond markets are down double digits since the start of the year. The U.S. economy will tip into a recession next year, according to nearly seventy percent of leading academic economists polled by the Financial Times. So what’s an investor to do?
Our first piece of advice is to ignore the economists! It’s not that economists are wrong, though they may be. Instead, we think the market itself is a fair predictor of the economy. Stock and bond prices rapidly reflect news about consumption, inflation, interest rates, supply chain issues, employment and such.
It appears to us that the market is pricing in the threat of a mild recession.
This makes sense in light of the strength of household and business balance sheets. The financial system is not in crisis as in the 2007-2009 downturn. The Federal Reserve is focused on both inflation and unemployment and will consider each as the future unfolds.
Usually, unemployment rises during a recession. The labor market is tight with 1.9 jobs available for every unemployed person. With such a tight job market, we might see employers remove vacancies and the newly unemployed still able to find new jobs.
Stock markets can take some time to recover from their losses. The following chart helps understand past market declines.
This chart of drawdowns of the S&P 500 index since 1950 shows the return since the previous peak. Values of zero indicate new highs. It is a valuable graphic showing the frequency, duration and magnitude of drawdowns. There have been three such events when U.S. stock investors lost about one-half of their assets. It can take years to recover even before adjusting for inflation.
Our second piece of advice is to size one’s investment in stocks to reflect one’s tolerance for risk and time horizon.
This leads us to the risk of attempting to time the stock market.
The preceding table shows the bottoms of bear markets defined as declines of at least 20%. Columns include the date of the bottom, the index level on that date, the previous maximum value of the index, the drawdown. The rightmost four columns show the return over the next 5, 10, 20, and 30 trading days. Below the table we show the average of the values (“Average if Bear Bottom”, and the average of all 5, 10, 20, and 30 day periods.
The table makes it clear that the returns immediately following a bottom are much stronger than the average across all periods.
The investor who exits the market hoping to avoid more loss risks missing significant gains.
This leads us to our third and final piece of advice – do not attempt to time the markets. Successful timing requires a disciplined and effective approach to both exit and re-enter the market. There is no proven way to time the market.