I’m going to start this post with a disclaimer. The following is a description of a strategy I am employing with my own assets. I accept no responsibility for any consequences, good or bad, of whatever you do with yours. The only actual advise I’m going to give you is to do your own research. This goes for anything posted on this blog but especially for a post of this nature.
Be fearful when others are greedy and greedy when others are fearful. – Warren Buffett
After a historic bull market has made investing experts out of novices everywhere, we are finally about to separate the wheat from the chaff. It’s easy to make money when everything is going up. Almost everyone does. But truly gifted investors get excited when the market is falling. They don’t just protect themselves in the event of a down market; they look forward to the many opportunities it will present. And finally in the last couple of weeks, we’ve seen an exclamation point added to the long building evidence that this is finally about to happen again. The FED gave up on its anemic effort to both raise rates to normal levels, which only got about halfway there, and to unwind quantitative easing by allowing the runoff of its balance sheet to move it towards more normal levels – again, it didn’t get anywhere close. Paul Volcker, that giant among Federal Reserve chairmen (both figuratively and literally, the man is six and a half feet tall), must be disgusted. Almost immediately after what is both widely and accurately being described as the FED throwing in the towel, the so called yield curve, which had been flirting with inverting for some time, finally did so. For those outside the finance world, the inverted yield curve is a nearly certain signal that a recession is around the corner.
Combine those blaring recession alarms with several other key indicators that have been more than hinting at one for literally years now, and the historical improbability of going even as long as we already have without one, and a recession is virtually etched in stone. Whereas the last one originated primarily in the housing sector, I believe this one will be more broad based. There is significant stress from diverse sources. The housing market is overheated again, albeit somewhat less so than last time and with a much less severe subprime problem. A large subprime auto loan bubble has developed and the default rate has been quietly increasing for some time. Americans young and old are weighed down by a mountain of non-dischargeable student loan debt with a high default rate there too. Substantial structural problems in the Chinese economy as well as several others around the world need to be taken seriously in what is now a fully global economy. And who can forget an unsustainably high national debt here at home? Since the FED has squandered a decade long bull market by acquiescing to political pressure to keep the pedal to the floor and failing to build an adequate buffer as a result, it seems this recession will be a relatively uninhibited one. Or to put it another way, it’s time to batten down the hatches.
As a finance man myself, I was among many of my peers in expecting this a few years ago and preparing for it accordingly. The good news for those who did not do so is that it turned out we finance folks were early. However, I’m 100% comfortable having missed the very peak of the mountain if it means ultimately avoiding going off a cliff. It looked like the market was finally correcting last December but that turned out to be only a precursor and almost everything promptly recovered. The next time will likely be different and if it doesn’t happen by the end of this year, I will be very surprised.
So what do I do to prepare for a recession? It’s a very simple approach. As we near what I believe is the peak, I gradually move any assets without tax consequences (401ks, IRAs, etc) out of stock exposure and into cash or in cases where there is no pure cash option, money market funds. With taxable investments, I do the same for the most part with the addition of harvesting any available long term capital losses at the same time to minimize tax liability. If I can’t do that, and it can be difficult in an “everybody wins” market like we’ve had for some time now, I will sell out anyway and take the tax hit. So for the short term, I’m giving up potentially larger returns in stocks and accepting low, but comparably stable ones in return – currently 2.45% and thereabouts. The risk I run is that as happened in this case, I will be too early and miss out on some upside. But no one can time the market and anyone who says he can is either lying or doing something that is likely to wind him up in a lot of trouble one day. And a small to moderate loss of upside is a small price to pay in my opinion when the reward is ultimately avoiding a 20% or greater collapse nearly across the board.
Of course the return on cash will decline when the FED cuts rates (what little it can in this case) and does everything else in its power to juice the market and soften the impact of the collapse. But that’s ok because the primary goal is to avoid losses; the small return on cash is just a short term bonus. Once there is blood in the streets, and that will almost certainly be the case when rates are being cut, that’s the time to shift from one end to the other in following the advice of one of the greatest investors of all time, Warren Buffett, which I opened this post with. I can’t predict exactly what will be going “on sale.” It may be everything or it may only be certain sectors/asset classes. Maybe stocks will fall so far that they’ll be too good to pass up. Maybe both real estate pricing and mortgage rates will decline so much that even this renter, who is thoroughly uninterested in homeownership, will become a landlord. Maybe I’ll look at investing more in small businesses.
I don’t know which opportunities will or won’t materialize but as always, I’m watching everything. Whatever you do, it will take balls to buy while everyone else is panicking and boarding up the windows. But if it were easy, everyone would do it. The underlying principle is to capitalize on the inefficiency created by people (and even computers, which control most stock trading now) operating emotionally rather than logically. The window may or may not stay open very long but it will almost certainly open. The important thing is to keep your eyes open and be prepared to act based on what you see.
And you don’t have to get fancy either. I’ll leave you with this as food for thought. If you had bought into the best and most basic stock fund (Vanguard Total Stock Market Index – VTSMX or VTSAX) anywhere between October 2008 and October 2009, your investment would be worth roughly 300% today – an 11.6% annual return for an entire decade. If you had nailed the bullseye and bought dead at the bottom, it would be closer to 400% – or 14.8% annualized. That would take some luck. But the 300% outcome of the year I mentioned would take much less. If you want to take a more conservative approach, use dollar cost averaging as opposed to dumping everything in all at once. You won’t get the biggest possible return, but you will be putting the odds of a strong long term outcome in your favor. Good luck everyone! And don’t forget to take luck out of the equation as much as possible by doing your research.