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Recession Odds and Soothsayers

“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.” – Peter Lynch

With the financial markets in “turmoil” in early 2016, the most common question asked of economic forecasters: “is the U.S. economy heading into another recession?”

At the February lows (1810 on the S&P 500, 15% correction), many answered yes. The stock market is a leading indicator of the economy, they argued, ignoring the many Bear Markets in history that weren’t associated with recessions (most recently in 2011).

odds1

With the S&P 500 over 10% higher today, more forecasters seem to be hedging that opinion. That’s to be expected, of course, as many pundits simply form their narrative on the economy based on the recent direction of the S&P 500. Higher = good economy; lower = bad economy.

But I digress.

What I find most interesting in the responses to the recession question is when they assign a specific probability of a contraction occurring. At the February lows, one notable soothsayer said there was a 50% chance of a recession this year. Another said the odds were higher, at 65%. Still another fortune-teller said there was a 100% probability.

Thinking in terms of probabilities in markets is a generally a good thing (as there is no such thing as certainty), but lost in these prognostications are the following issues:

1) How are you defining recession and are you actually calculating those odds in accordance with that definition or just pulling a number out of thin air?

2) What are the odds of a recession at any given time? How far back in time are you going to determine those odds?

3) What were the times in the past that had similarly high odds with no ensuing recession?

4) By the time you can say with any certainty that the economy is in a recession, is it of any use to investors or does it do more harm than good? Are you equally adept at predicting when a recession is about to end and when investors should get back in?

Let’s attempt to address each of these questions.

1) How are you defining recession and are you actually calculating those odds in accordance with that definition or just pulling a number out of thin air?

The odds of a recession will naturally vary based on your definition. Some pundits use a single, arbitrary data point (ex: ISM Manufacturing under 50). Others use the layman’s definition (two negative quarters of real GDP). Most, I suspect, are not calculating anything and just throwing numbers out there to make headlines.

The official arbiter of recessions in the U.S. is the National Bureau of Economic Research (NBER). They define recession as a “significant decline in economy activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

Are we seeing such a decline today? An objective response is not as of yet, which begs the question: what are the indicators these pundits are using to arrive at odds of 50-100%?

2) What are the odds of a recession at any given time? How far back in time are you going to determine those odds?

These are important questions that are rarely addressed. There is always a chance of recession at any given point in time and depending on how far back in time you go, your odds will change.

The NBER has data on U.S. recessions and expansions going back to 1854.

If we use the data from then until now, the odds of recession occurring at some point in the next year (at any given time) is 48.8%. Now, back in the 1800s and early 1900s, recessions occurred with much more frequency, pushing up the overall odds.

We can see this in the chart below. Since 1950, the odds of a recession occurring in the next year is only 28.2%. And since 1985, the odds drop all the way down to 18.5%.

odds2

The point here is that some perspective is necessary when hearing recession odds and that if you are calculating those odds based on the past 30 years, they will be far lower than if you go back further in time. You can easily torture the data to conform to your prevailing bias.

3) What were the times in the past that had similarly high odds with no ensuing recession?

This question is never asked as it is taken as a given that the recession call will be correct. Just because there is a probability of a recession occurring, and at times a higher than average probability, does not mean there is any certainty. And predicting recessions can be a dangerous game for investors when they fail to occur as we last saw back in 2011 when the S&P 500 declined over 20% leading to a number of prominent recession calls. The S&P 500 would more than double from its 2011 lows in the next four years while no recession ever occurred.

4) By the time you can say with any certainty that the economy is in a recession, is it of any use to investors or does it do more harm than good? Are you equally adept at predicting when a recession is about to end and when investors should get back in?

The NBER announced on December 1, 2008 that the business cycle had peaked in December 2007. At that point, the S&P 500 had already declined 48% from its peak in October 2007 (1565 to 816).

The NBER announced on September 20, 2010 that the business cycle had troughed in June 2009. At that point, the S&P 500 was already up 40% from the December 1, 2008 announcement date (816 to 1142).

This is just one example but clearly illustrates the risk of basing investment decisions on whether the U.S. economy is in or out of a recession. Why? Because the stock market is a leading indicator, and by the time you can say with certainty that the economy is in recession a substantial portion of the decline has often already occurred. Conversely, by the time you can say that a recession has ended and a new expansion has begun stocks have already moved significantly higher.

To be really useful to investors, then, the recession prediction needs to be made not only in advance of the beginning of the recession but in advance of the beginning of the stock market decline. Naturally, the odds of a recession will be lower at such times leading to more false predictions. The risk of acting on these forecasts, of course, is that no such recession occurs.

The Price of Admission

As Peter Lynch said in the quote above, you “get recessions” and “have stock market declines.” This is a fact of life and the price of admission when it comes to investing. If you can’t handle this, you will not do well in the markets because your emotions will eventually get the better of you, selling after large declines/bad news and buying back in after large advances/good news. Needless to say, this is not an effective investment strategy.

If you are worried about a recession/stock market decline and you have 20-30 years to retirement, you are not thinking logically. Mathematically, the best scenario for those with long investing horizons who are adding to investments every year is for stocks to go down, not up. This gives you the opportunity to buy in at lower prices for higher prospective returns. For those closer to retirement, if you are absolutely terrified of a stock market decline you probably hold too high of a percentage in equities, and perhaps need to reevaluate your true risk tolerance.

As for the soothsayers and their predictions, ignore them at all costs. They may be correct in calling for a recession this time around but that does not translate into an investment strategy. They have nothing to lose in making bold calls but you as an investor have everything to lose in deviating from your long-term investment plan.

7 Years

The current expansion will hit seven years this June. The longest expansion in U.S. history was 10 years (from March 1991 to March 2001), suggesting that we are likely closer to the end of this recovery than the beginning. But those are only odds, probabilities, telling you nothing about the path of security prices or the economy over the next few years. Even if there is a recession in the next year, what if stocks only decline 20% as they did in the 1990-91 recession? What if the recession is shallow and short-lived as it was in January-July 1980?

Many seem to be assuming another 50+% decline because that’s what we saw in the last two bear market/recessions, but this is far from a given. And what if this expansion ends up lasting more than 10 years (breaking the record) and you sold all your stocks in February (or worse, back in 2011) because you were worried about another recession? What then? When do you get back in? Perhaps that’s an unlikely scenario, but it is not impossible. Predicting recessions is a hard business but harder still is building an investment strategy based on those predictions.

The future is unknown as is the precise path of security prices. Which is why having an asset allocation plan and sticking to it is paramount. If your destination of choice is long-term investment success this is the only proven road.

For our latest award-winning research paper, click here.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie-Bilello

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

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