In a recent Barron’s article, Ben Levisohn pointed out something that I’ve been saying for quite some time: when bear markets occur without a recession, they tend to be shorter and shallower. This may be cold comfort to anyone who has over-invested in asset classes like energy stocks, commodities, or junk bonds. These folks are experiencing their own bear markets, while the S&P 500 is only down about 10% from the last high back in May 2015.
Levisohn says there is a very good chance that the U.S. will avoid a recession in 2016. The economy is still cranking out close to 200,000 jobs a month, and labor growth shows little sign of slowing. The employment picture is still bright, with 2.5 times as many job openings as people collecting unemployment insurance. And while manufacturing is relatively weak, it only makes up about 12% of the U.S. economy. The services sector makes up 86%, and it appears to be holding up well. In the past, the strength in the services sector helped the U.S. weather weakness in manufacturing, as was the case during the emerging market crisis of 1998-99.
The point of the Barron’s article was that, even if the market continues to sell off and eventually reach bear market status (about 1700 on the S&P), it will probably be shallower and recover more quickly than it would if the whole economy tipped over. Levisohn points to the 34% drop in the S&P 500 in 1987, the 22% drop in 2011, and the 23% tumble during the emerging market crisis of 1998. These bear markets were not linked to recessions, and they were shorter—a median of five months—and the drops smaller—26% vs. 38% for selloffs accompanied by recessions.
No one knows for sure whether or not a recession will happen in 2016, but the economists I follow are handicapping it as a low probability event – less than 15%. So here’s what I’m telling my clients to do right now. There’s little to be gained by bailing out of this market when it’s down 10% with no recession on the horizon. If they have cash, it’s o.k. to add to positions that have gotten hammered particularly hard. If conditions in the real economy deteriorate significantly, such that the threat of recession rises to 50% or more, then it may be time to act. But by that time, the market will probably have discounted the recession threat. This is the investor’s dilemma – how to get out of the way of a recession before it’s already reflected in the market.
There are no foolproof ways to do that, so for most investors the best strategy is to just ride out the storm. But for those who would rather proactively manage the risk of things getting a lot worse before they get better again, the odds aren’t very good. If we manage to avoid a recession this year, the market is likely to bottom out before we hit the -20% mark. Since we’re already down -10%, the potential gain from selling now is only 10%. But the real danger in this strategy is the possibility of missing the rebound. At some point, you have to decide that the threat has passed and it’s time to get back in. I don’t know of very many investors who are able to do that successfully. More often than not they wait too long, and end up paying higher prices. If you are willing to accept that as the cost of protecting your portfolio, then go ahead and sell now.
If, on the other hand, the economy tips over this year, the market could be in for much more than a -20% slide. In that scenario, you would be much better off for having played defense. But the same problem remains for the completion of this round-trip trade. How will you know when it’s safe to get back in? Do you think you will know? You may be overconfident about that. One study I saw showed that the odds of correctly timing both the exit and the re-entry, over 3 market cycles, was minuscule. You may pull it off once, or even twice, but any more than that is highly unlikely. And don’t forget – you can win the out-and-back-in bet by a small margin, and end up losing on the deal because of trading costs and taxes.
If it sounds like I’m against anyone ever attempting this strategy, I’m really not. But what I am saying is that it’s very hard to do, and you have to have a detailed plan in place so that you don’t let it turn into a series of emotion-driven trades. That is a surefire way to lose a lot of money.