The Federal Reserve has significantly raised interest rates over several months to curb inflation. The good news is that it’s working. The consumer-price index (CPI), a broadly-used measurement of inflation in the US, rose 6.5% last month from a year earlier. This is down significantly from its 9.1% peak in June of 2022.
This is good news for inflation. And yet, interest rate increases and negative stock returns throughout 2022 have some investors concerned a recession is on the horizon. As always, there is much debate among economists about whether or not we can expect a recession in 2023. Among those expecting a recession, there are significant differences in predictions on how long it might last and how deeply it will impact individuals and businesses.
Sensationalized headlines can certainly be alarming and overwhelming, so let’s gently step back and take a larger view of what it all means and how it affects you.
What is a Recession?
A recession, or significant period of economic contraction, is a normal part of the economic cycle (pictured below). As part of a healthy system, we fully expect the economy to expand and contract over time, but no one can reliably predict how long the expansionary or contractionary phases will last or when the exact peak (high) or trough (low) will be.
A group of expert economists from top universities called the National Bureau of Economic Research (NBER) defines a recession as follows: a significant decline in economic activity that is spread across the economy and lasts more than a few months. To determine where we are in the economic cycle, they evaluate a significant amount of data – including nonfarm payroll employment, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, and industrial production. This is backward looking data that takes time to gather.
Markets quickly incorporate financial information, so by the time the NBER has had a chance to gather and analyze the relevant economic data and determine that we’re officially in a recession, markets have often already reflected the downturn.
Since it’s impossible for even the smartest of economists to predict exactly when the economy will contract, this leads to the next logical question:
What Does a Recession Mean for Investors?
The silver lining here is that portfolio returns have often been positive once the NBER has actually determined that we’re in a recession. Data covering the past century’s 15 US recessions show that investors tended to be rewarded for sticking with stocks [1]. In 11 of the 15 instances, or 73% of the time, stock returns were positive two years after a recession began. The annualized market return for the two years following a recession’s start averaged 7.8%.
For a longer-term perspective, historically US stocks have averaged positive returns over one-year, three-year, and five-year periods following a steep decline. Exhibit 1 shows the average cumulative returns after steep market declines since 1926.
Exhibit 1: Fama/French Total US Market Research Index Returns (July 1, 1926 to December 31, 2021)
Zooming all the way out, Exhibit 2 below shows the growth of $100 from 1926 through 2021. The shaded green areas represent official recessionary periods. While it can feel like a significant event when you’re in a recession, you can see each is a blip on the radar of an investment lifetime.
Exhibit 2: Growth of $100 (1926 to 2021)
What Should I Do to Prepare for a Recession?
1. Remain Calm
Even though market fluctuations and financial news outlets doom and gloom can feel uncomfortable, markets and economies around the world are, and always have been, cyclical. Market downturns and economic recessions are an expected part of the cycle.
2. Refocus on the Long-Term
As an investor with a long-term perspective, your advisor has specifically constructed your portfolio based on your goals to weather market ups and downs. Market cycles have been factored into your financial and investment plan, so sticking with this plan and focusing on what you can control during times of market volatility is the most responsible thing you can do for the future. This varies for everyone, but could look like continuing your long-term contribution or withdrawal schedule, making sure you’re maxing out your 401(k) and that it is properly invested, and/or ensuring you have insurance and estate planning in place to protect you, your loved ones, and your portfolio.
3. Your Abacus Team is Here for You
Remember that your Abacus team is working to make lemonade out of lemons in your portfolio. You have a full-time trading team always working behind the scenes to find new opportunities on a daily basis. There are several tools we have to do this:
Rebalancing
We are constantly monitoring your portfolio to ensure it’s still in line with the mix of stocks and bonds you and your financial advisor have deemed appropriate based on your near and long-term goals. When stocks and bonds go up or down in value, that can throw off your preferred allocation. We use these opportunities to buy and sell to bring you back to balance. Hence, rebalancing! The same thing happens when an asset in your portfolio declines more than the rest. We sell a portion of the asset that held up well and reinvest the proceeds into the asset that declined at a discounted price – effectively buying assets on sale. For example, over the past year stocks have declined in value more than bonds. To rebalance your portfolio, we’ve been selling bonds and buying stocks at a steep discount, setting your accounts up for the next market upswing.
Tax-Loss Harvesting
Investors are responsible for paying capital gains tax when they sell assets that have increased in value, referred to as realizing capital gains. When markets are down, we’re able to do the opposite and realize capital losses in the portfolio. These capital losses can offset capital gains in the current year and potentially offset up to $3,000 of your ordinary income, reducing your overall tax burden. If there are realized capital losses above and beyond this, you can even carry them forward to offset future capital gains. We look for opportunities for tax-loss harvesting every year, but as you can imagine this strategy is particularly effective when markets are volatile.
Keeping the Long View
Much like market volatility, recessions may feel uncomfortable but they are a normal part of a healthy financial cycle. At Abacus, we even find opportunities in recession to strengthen your portfolio to maximize your long-term goals. We are always happy to answer any questions or concerns you may have. Whether you feel compelled to reach out or not, just know we’re always hard at work making sure no opportunity goes unexplored.
References
[1] Fama/French Total US Market Research Index: The value-weighed US market index is constructed every month, using all issues listed on the NYSE, AMEX, or Nasdaq with available outstanding shares and valid prices for that month and the month before. Exclusions: American Depositary Receipts. Sources: CRSP for value-weighted US market return. Rebalancing: Monthly. Dividends: Reinvested in the paying company until the portfolio is rebalanced.
Disclosure
Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Abacus Wealth Partners, LLC [“Abacus”]), or any non-investment related content made reference to directly or indirectly in this blog will be profitable, equal to any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Abacus. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their individual situation, they are encouraged to consult with the professional advisor of their choosing. Abacus is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of Abacus’s current written disclosure brochure discussing our advisory services and fees is available for review upon request or at https://abacuswealth.com/.
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