Recession Anxiety

If you knew these last 3 recessions were going to happen, how would you have prepared? Will you be prepared for the next recession?  Does it matter?

The reality is that if you believe in capitalism and stick to a diversified market portfolio OVER TIME you will be alright—afterall, a quick look at the history of the Dow Jones Industrial Average ($INDU) should put your nerves at rest…

…BUT… what about all the crashes and bear markets of the past… Could you be better prepared? …AND… what about all the news (from very smart people like Ray Dalio) that the world has changed! The founder of Bridgewater Associates, thinks we’re back to the late 1930s. In an Aug. 28 LinkedIn post, as well as recent television interviews, he described three similarities between today and the decade that brought us the Great Depression. According to Dalio, if the economy begins to slow, these similarities may “produce serious problems.”

…AND… what about news from people that have predicted doom and gloom in the past successfully like Michael Burry (of “The Big Short” fame) who recently said: “The dirty secret of passive index funds — whether open-end, closed-end, or ETF — is the distribution of daily dollar value traded among the securities within the indexes they mimic.” “In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those — 456 stocks — traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different — the index contains the world’s largest stocks, but still, 266 stocks — over half — traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks.” “This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”

You get worried… You ask, what if the world has changed? Just look at all this nationalism… that’s new right?

…But… then you realize, the market eventually did go up after the Great Depression of 1929… And the Great Recession of 2007.

…BUT… there is all this news about the Yield Curve Inversion and you think… maybe you can prepare your portfolio for this… after all if you look at the last 3 recessions of 1990, 2001 and 2007 and overlay the difference between the 10-year and 3-month Treasury rates on top of these 3 recessions and see how it compares to where we are today (September 2019)—yikes, we are sitting at 37.93% and it seems like many past recessions were predicted when the probability was approximately 30%– The $INDU index is currently ~27,200.  (note: The NY Fed has some history on using the difference between the 10-year and 3-month Treasury rates to calculate the probability of a recession in the United States twelve months ahead.  There are some practical issues with this model outlined here. )

So, you call up some experts and ask them and they say: “The yield curve inversion does not always lead to a recession. In fact, economist Ed Yardeni has noted that an inverted yield curve can occur prematurely. For example, it turned negative a couple of times during 1995 and 1998, but a recession did not officially begin until March 2001. Therefore, we don’t think a recession is certain and more data is needed to make an intelligent decision.”

You say to yourself—JUST CALM DOWN and remember what John Templeton said, “I never ask if the market is going to go up or down because I don’t know. It doesn’t matter. I search nation after nation for stocks, asking: ‘where is the one that is lowest priced in relation to what I believe it’s worth?'”.  You get it, Microeconomics is the study of individuals and business decisions (supply/demand, labor costs, production costs) and that is what is important for investing…

…BUT… more Macroeconomic news about Monetary Policy (Fed cutting rates & printing money), Trade Issues with China, Wealth Inequality (In 2016 the top 1% shared ~40% of the wealth versus ~25% in the 1980s), US GDP and Dept being way out of whack.

But you get comfort in remembering that Warren Buffet never listens to economists.

Then you calm down again and realize you are not a trader… you are an investor and you are going to have trust in capitalism and your long-term investment strategy.

…BUT…

We all use the same data…

I had a money manager say something to me the other day that struck me as odd—so I thought I’d dig in a bit to see if I can rationalize his comment.   He said, “We are all using the same data” when I asked him about an opinion that I heard from someone else about the stock market over the next few months. His basic point was that the market is about valuations & fundamentals” (more) and significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals.  Therefore, if you use tried-and-true analysis of a company’s discounted cash flow to make your valuation decisions you will be fine over the long run.

I think the most important thing he said was “over the long run”.  Because some investors do have access to fundamental data (private feeds) that others don’t and if a proprietary feed is faster and gives the investor a ‘speed advantage’ in trading then that is an unfair advantage. For example, if the price of a stock goes from $100 a share to $95, and you know that and someone else doesn’t, it makes sense to sell at $100 to a buyer when the investor knows the price is now $95. If you are a high-frequency trader and you know prices are changing millions of times a day across many securities, you can make a great deal of money.

“…our system for telling investors what stocks are worth should be straightforward. Instead, we have created a two-tier system of stock-price information—a lower-quality public feed and generally higher-quality private ones.”  Commissioner Robert J. Jackson Jr. (more on Public versus Private feeds)

Some investors also have access to “alternative data” like satellite imagery to analyze information such as parking lots, web scraping to track items such as consumer preferences and geolocation data to analyze information such as consumer traffic to certain stores.  With tools like Artificial Intelligence/Machine Learning the new Quant 2.0 Wall-Street geniuses can take proprietary fundamental feeds and these new alternative datasets and do Algorithmic trading to uncover value faster than any old school hedge fund manager (example).

But at the end of the day, you don’t have access to any of these tools… So, if you can suffer through all the volatility and you trust that your money manager is on top of your portfolio’s underlying fundamentals then yes, the market can still work for you over the long run.  However, just know that many strategic investors will have made a lot more money than you, on those same investments, by leveraging better tools and quant 2.0 type talent.

…you can throw all this long term investing out the window if you have a mere $7.5 billion to invest and then Bridgewater Associates can do it for you and you will likely do very well.

While the Quant’s and AI-powered algorithms can crunch numbers and make an investment decision, they can’t offer the human touch and it has become evident to me that the human touch is an essential component to long-term investing—net: you need a coach to get you through the stress of the volatility–get a good money manager.

Footnote: and never forget that you need to respect market sentiment.