It’s time to prepare
The time to prepare for the next recession is now. It is probably several months away, but those who are prepared stand a much better chance of coming through it with minor damage to their portfolios.
I developed an econometric model whose sole purpose is to forecast the likelihood of an oncoming recession. My model doesn’t give a specific date for the recession. It gives a range of dates where the risk of a recession is high enough to justify defensive measures to protect capital. The model generates a recession warning with a 6-12 month time horizon.
At the end of April, the model gave its first warning since the last recession ended in 2009. That doesn’t mean that a recession is imminent, or that you should go to cash now. What it means is, it is likely that a recession is coming sometime in the next 6-12 months.
How the model works
The model has two types of indicators. Leading indicators are forward-looking and are designed to anticipate the track of the business cycle as we move forward. Coincident indicators are real-time data points that either support or contradict the leading indicators.
No definitive signal can be given by the model until both sets of indicators are in agreement. When that happens, the model has an 88% forecast success rate, going back to 1957. Here is the model as of May 25.
There are 7 indicators in the model, and each has a sub-set of data points that are available to the public for free. The primary indicator is the R-Score, which is a compilation of all the leading indicators into one number.
All the numbers you see in the table represent the range of risk for each indicator. 1 is the lowest reading, and 9 is the highest. A reading of 9 is a “hair on fire” warning.
You can see that there are no readings higher than 5 at present. The reason for the recession warning is that the R-Score reached level 5, which is enough to sound an early warning. It may go back down next month, but there’s no guarantee that it will.
Here is a brief description of what each indicator means.
The Traffic Lights
As a way to put all of the indicators together and display them in an intuitive way, I use a traffic light metaphor. Everyone knows what traffic lights mean.
The yield curve captures the entire spectrum of interest rates, from riskless Treasury bonds to Junk Corporate Bonds. The curve has been flattening lately, but it has not inverted. When it does, this light will change color.
The misery index is a combination of the unemployment rate, inflation, consumer debt, and wage growth. It represents the condition that consumers are in, and how likely it is that they will support economic growth.
The consumption and production categories represent the balance of supply and demand for consumer goods. Today, companies are cranking out high volumes of goods and services, but consumers are a little stretched, owing to high household debt and sluggish wage growth.
Why it’s important to avoid recessions
Clients often ask me why they should go to all the trouble to change their portfolio allocations when a recession is coming. My answer is illustrated in the chart below.
There have been two recessions since the turn of the century, and my model gave warnings at the early stages of both. My clients who heeded the recession warnings, and got out of the way, made 2X the returns that my buy & hold clients did.
I didn’t get my clients out of the market at the top in either of the recessions/bear markets, but I did get them out before the big damage was done. And I got them back in early enough in the recovery that they were able to lock in some significant gains versus the buy & hold investors.
The Chart
Avoiding recessions is a choice, not a mandate
I am not against a buy & hold approach to investing. The returns over the long arc of history are very good. But for those investors who are getting close to the point where they will start withdrawing from savings to fund their needs after they no longer receive a paycheck, avoiding recessions becomes more and more important.
It’s important to note that this is not a market timing strategy. It’s a capital preservation strategy. Recessions only come along every 7-8 years on average, so most of the time you will be safe in your buy & hold approach. It’s only when the harsh winds of a recession are howling that I advocate some kind of defensive strategy, just to dampen the pain of the bear market that will follow.
As always, if you would like to learn more about avoiding recessions, contact me through my website.
Simple & Strong…Thanks for sharing Erik.
Thank you. I appreciate your logical and data-based approach when so much of the ‘expert’ advice is trending toward emotional responses to issues that may or may not have any real relevance.