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Timing the Next Recession: It's not a matter of "if", but "when"

Timing

Timing the Next Recession
October 1, 2018

"Time in the market is more important than trying to time the market"

DISCLAIMER: I do not believe that the majority of investors should try to time their investments into the stock market by buying massive amounts of stock when they deem the price to be "low" and selling stock when they deem the price to be "high". This post does not serve as a means to suggest anything otherwise, but I would like to share my views on the economy as a whole and why I believe the next recession hitting is just a matter of time.

First, the definition of "Recession": a period of temporary economic decline where trade and industrial activity are relatively reduced, identified by a fall in GDP

Next, the definition of "GDP": the total value of goods produced and services provided in a country during a period of time (Quarterly and Annual timeframes are the most commonly reported)

At the must fundamental level, a recession is when the economy doesn't just slow in its rate of growth, but it actually retracts in value. For example, if this year's GDP was $20 Trillion, and next year's was only $19.9 Trillion, that would signify a "Recession".

With that in mind, it is easy to see that recessions can vary in length and in depth. Here is a view of how the recessions in the past 100 years impacted the stock market:

MarketTiming

As you can see, the stock market usually falls during recessionary times. This is because the slowdown in economic activity has a direct effect on the underlying businesses in the economy (duh) but does not kill all of them off completely. This brings opportunity for investors because their stock prices will fall during the recession, but they will rebound as business growth picks back up.

This information brings us to the crossroads where we realize that ideally:

  1. We want to buy stocks at "low" prices
  2. We want to sell stocks at "high" prices
  3. We want to use our knowledge of the economy as a guide to determine when prices are "low" or "high"

We can try to accomplish this goal of buying low during recessionary times and selling high in boom times by using a template carved out for us by one of the most successful investors in history, Ray Dalio. Ray talks at length about how the Debt Cycle is really the most important lever on the economy and how it grows/contracts. Why?

When money is cheap (interest rates are low, and debt is easy/cost effective to acquire) people will borrow said monies and buy houses, build factories, and this spending boosts the economy.

When money is expensive (interest rates are high, debt is harder/more costly) people will not borrow as much money, and this leads to less purchasing, less development, less spending, and so on and so forth.

Interest rates (the cost of borrowing money) are mainly controlled by a country's central bank. In the glorious US of A, that is the Federal Reserve. In Japan, it is the Bank of Japan, each country has their own central bank that controls interest rates. One cool exception is in Europe, where the countries in the whole European Bloc share a central bank. (Very creatively named the "European Central Bank", or "ECB")

For those that don't know, money has been incredibly cheap at a global level for the past 10 years since the great recession in 08. This is because central banks (The Federal Reserve, the ECB, and all of their companions) had interest rates pegged at basically zero to spur growth in the economy. And because Interest rates at 0 means it is basically costless to borrow more money, people will borrow more and use it to build more things, buy more stuff, etc. This acts as a turbo-boost for the global economy.

And it WORKED! We have had a pretty good recovery so far, especially understanding the fact that the last recession was the deepest since 1929.

But, and there is a BIG BUT, if you paid attention to how interest rates work. There is only one way to go from zero.

That's right, interest rates have been (slowly but surely) on the move up. This makes the cost of money higher, which may deter people from borrowing money. The 1% difference in the cost of a mortgage, or in the cost of building a factory, makes a very big difference.

In fact, the difference between a 4% interest rate and a 5% interest rate on a 30 year mortgage for a $500,000 home is over $100k in interest expense over the life of the loan. Wow!

All of this to say that as interest rates go UP, the value of financial assets generally will go down, and the higher cost of money will act as brakes on the car that is our economy. And our central banks are starting to put those brakes on as we speak.

This interest rate dynamic, coupled with extremely tight labor markets (unemployment at all time lows) and a white hot economy (GDP growing at ~4%/year, when the historical average is about 2-3%/year) just mean that there are only two things that can happen. This goldilocks period in the economy will last forever, or things will start to slow down and the economy will recess at some point.

I am of the belief that things don't last forever, especially not in the economy. If you agree with me, there is a combination of things we can do to prepare for a recession:

  1. Save more money in cash as a cushion (this is dry powder for when things get hairy, we can take shots at all of the investments that become attractive)
  2. Buy higher quality assets (by their nature, high quality assets do not fall in value as much as lower quality, more risky assets)
  3. Lower fixed expenses so that overhead is lessened in times of economic stress (once again providing more financial freedom to take advantage of lower prices)

A combination of these three things will recession-proof your financial life. Things will go awry, you may lose a job, your investments will drop in value, everyone will be calling for the end of the world. But with a solid mix of the three points above, you will be able to weather just about any economic storm.

I am not sure exactly WHEN the next economic recession will occur in the United States, but I can tell you that I am financially preparing for it by saving a higher % of my money in cash, taking flight to higher quality investments, and keeping my living costs as low as possible to be able to coast in crisis mode for as long as possible.

If you are looking for a great (free!) book on the topic of debt cycles and how they impact your investments, check out Ray Dalio's book on it. For another great book by him, read Principles: Life and Work, it is a great lesson on making mistakes, learning from them, and growing as a person. I HIGHLY recommend it!

Nico

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @nico_pasq, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

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Nico Pasquariello

Promoting Financial Literacy Through the Use of Common Sense



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