Apart from Willem Buiter (indeed, the Dutch/British economist who was stalked by Heleen Mees), nobody seems to be talking about an impending recession. Now that he is warning us for one, I find myself in good company. There are numerous red flags:
- Corporate revenues are falling
The only time we have witnessed declining business revenues was in 2001 and 2008. And you may be able to guess it: in both cases it was followed by a recession! (see this graph from the St. Louis Fed)
- International trade is slowing down
Recent data has shown that international trade has declined by 8.4% over the past 12 months. HSBC has stressed that such strong declines only occur during recessions.
- Corporate profits are falling
My expectation was that corporate profits would decline in the second quarter, but it appears to take a little longer. The current expectation is that corporate profits will decline in the fourth quarter. In turn, declining profits means a negative growth and lower stock prices.
- Business inventories are strongly increasing
The past quarters have shown a clear trend: the largest part of economic growth is fueled by an accumulation of inventories. But the ratio of inventories/turnover indicates that a recession is near. The ratio is rocketing. As a result, wholesalers are increasingly stuck with unrealizable inventories that have to be written off (at the expense of the GDP).
- Stocks are overvalued (but its prices are decreasing?)
Stock prices follow the business cycle. Currently, investors are paying a lot for one euro of equity on the stock market. That means buying into negative future returns on investment; or more precisely, you’ll be paying for a final glance at an economic expansion.
In sum, all signs point towards a recession. And don’t forget that a recession isn’t called a recession until it has actually passed. You can draw an analogy with meteorologists only calling a storm, a hurricane, when it has left a trail of destruction all over the country. Hurricane warnings wouldn’t even exist! Always remember that the equivalent of a hurricane warning doesn’t exist in the financial markets. If you hear about a recession on TV, it is far too late for you. In fact, the recession will probably have started at least six months ago.
A Recession Always Comes with a Market Crash
While the opposite isn’t always true (a market crash isn’t always coupled with a recession!), it is an inescapable fact that every recession comes with a market crash.
Historically speaking, we are currently overpaying by 50% for every euro of equity on the stock market.
This implies that a repetition of the 2008 stock market crash is a realistic scenario. However there is one difference now, compared to then: interest rates are practically zero. Therefore, if a recession strikes, there will be enormous losses on bonds as well.
Is Your Portfolio Recession-Proof?
Now let’s take a look at your portfolio. We want to find out whether your portfolio is recession-proof (robust), or whether it is vulnerable to a new recession. Your wealth may be invested in a number of different investment categories:
- Liquid assets
Examples are: your current account holdings at the bank, but also saving deposits and money market mutual fund accounts.
We have to discriminate between government bonds and corporate bonds, as well as the creditworthiness of the underlying governments and businesses. It is also important whether you have bought these bonds yourself, or whether you are investing in these bonds indirectly through an investment in a bond funds. Finally, the maturity of the bond is important.
Here we divide your stock holdings into several categories, in accordance to their respective industry and geographical location.
Here we can make a distinction between the futures market and physical commodities (like precious metals).
Now we have to ask ourselves the following: what makes an investment portfolio recession-proof? The answer is quite simple (but not easy): we have to avoid assets that are the most cyclical. Some investments are best left out when a recession strikes. Here are some examples:
- Stocks – and in particular the most overvalued stocks valued using traditional valuation techniques – listed in stock markets that are "expensive." Examples, among others: the United States, Europe, but also India.
- Bonds and/or shares of companies with high levels of indebtedness.
- Shares of companies that pay out a large portion of their profits (or more than its net profit) as dividends
- Shares of banks
- Actively managed stock funds that do little, or no, hedging
- Actively managed bond funds, especially if they invest in these risky bonds
- Private equity: the M&A market (mergers and acquisitions) comes to a halt during recessions, as credit becomes hard to obtain.
- 'Junk bonds' or risky (corporate) bonds
- Government bonds issued by less creditworthy countries
- Industrial commodities. However, many commodity prices have already declined by such an extent that the risk of a recession may (partially) be priced in already.
This isn’t a list of investments you’ll have to avoid for the rest of your life. But at the peak of a credit expansion, it is wise to follow this (undoubtedly incomplete) list. Ironically, these are often interesting investments when a recession is taking place, or has taken place already. But don’t forget that many investment categories also have long bear markets, as was the case with the U.S. stock market during the 1970s.
Analyze Your Own Portfolio
There are a number of questions that you will have to ask yourselves to see whether your portfolio is ready for a potential recession:
1 Is your wealth invested in a bond fund or do you own bonds yourselves?
A lot of investments are financed with borrowed money (margin debt). When panic breaks out in the market, and prices decline, many investors have to sell large parts of their portfolio without any individual distinction. During recessions, bond funds have to deal with participants who want to sell their stake. As a result, the fund is forced to sell their bonds at a point when prices are low. The fund isn’t able to hold its bonds to maturity, and premature sales lead to (potentially substantial) losses. Stocks are affected in the same way. So in fact, you will become a victim due to the actions of other participants in a bond or stock fund.
2 How much of your wealth is invested in liquid assets?
Recessions also offer opportunities, but in order to seize them you must have the right tools. Smart investors will only liquidate their stock holdings in times like these: when they are anticipating a recession, and when stocks are overvalued. They will only start buying again when stock prices are substantially lower. In the meanwhile, they will hold on to their cash (as cash = king), or very liquid investments like gold (which some consider to be a currency). Seth Klarman – a legendary American investor with billions in assets under management – didn’t blink an eye when more than 50% of his portfolio consisted of liquid assets during the dotcom crash. During the market correction, he was able to buy a lot of assets at bottom prices. This is how he’s been able to make double digit returns, each year (!), for decades now.
3 How sensitive are your stocks to a market crash?
In 2008, the Dutch stock market – AEX index – lost half of its value. But suppose you owned shares of the Dutch ING bank. ING crashed and its price fell from 25 euros to 5 euros per share, losing 80% of its value (!). It is recommended to check your positions with the following criteria in mind:
- Are your shares listed in the U.S. or in Europe?
- Are you invested in 'popular' sectors such as biotech or internet?
- Is the price-earnings ratio and price/book value ratio of your stocks (substantially) higher than the average of the index?
- Do you own shares of banks?
- How much debt do your companies have relative to their equity?
- When will these companies have to refinance their debts?
4 How robust are the (corporate) bonds that you own?
If you own corporate bonds, you might want to ask yourself whether the financial conditions of the underlying companies are solid. Similar to the criteria listed under (3): how much debt do they have? How much interest do they pay on their debt as a percentage of gross profit? When does the debt have to be rolled over? Is more and more debt taken on?
Gold Completes the Yin and Yang
An investment portfolio without gold is the same as yang without yin. Especially during recessions, gold is an important counterweight in your portfolio. Furthermore, it is important to reduce your stock holdings (preferably the riskiest ones) and, partially, your bonds holdings. The obtained funds can then be invested in liquid assets or gold. The same principle applies to your (open ended) stock and bond funds investments, as these funds may run into a serious problem when faced with a lot of redemptions.
Other commodities may also face difficulties; in 2008, the prices of many commodities declined, with the exception of gold. A similar scenario could happen again.