The recession is coming???

The current bull market, which started around March 2009, has been the longest bull market since WWII. With the current bull run, the stock indices have increased by a significant amount. The Dow Jones Industrial Average went from around 8,200 points to over 24,000 points, an increase of 193% or around 21.4% annualized. The S&P/TSX Composite Index went from around 8,100 points to over 14,500, an increase of 79% or around 8.8% annualized.

As investors, we have been rewarded handsomely.

However, the longer the bull run lasts, the more people begin to get worried about a recession. Over the last few years, there have been many discussions on when the next recession might happen. So people analyze indicators like the historical P/E ratio, unemployment rates, building permits, housing prices, etc to determine the likelihood of a recession.

One of the more interesting indicators, I think, is the yield curve.

The yield curve looks at the difference between the yields on short-term and long-term US Treasury bonds. As you may know, yields on long-term bonds are usually higher than short-term bonds. Because investors typically demand more yield for a long-term investment to compensate for the greater risk they are taking on.

When we look at the past few recessions, something peculiar happened – the yield curve was inverted prior to the recessions.

What does that mean?

An inverted yield curve means that the short-term bonds (i.e. 2-year bonds) have higher yields than the long-term bonds (i.e. 10 years). This is an abnormal situation because essentially the inverted yield curve indicates that investors believe the economy will be better in the long-term than the short-term. So, investors are demanding more yield for a short-term investment because the near-term risk is much higher.

The yield curve inverted before the recessions of 2009, 2000, 1991, and 1981.

Recently, on Dec  3, 2018, yield curve inverted for the first time since the 2009 financial crisis recession. The yield on the US Treasury five-year note was 2.83, slightly lower than the three-year note’s 2.84 yield. The inversion was worsened on Dec 4.

Does this mean a recession is coming?

Should we freak out?

Yes and no.

In the past,  the yield curve inverted 1 to 3 years prior to the recession, and typically when we talk about the yield curve inversion, it’s the spread between the 10-year bonds and the 2-year bonds. So when the yield curve inverted, the recession did not come immediately. The yield curve simply indicated that there was a very high chance a recession was brewing. In other words, although the yield curve inverted a few weeks ago, we probably won’t see a recession immediately. The inverted yield curve simply indicates that the likelihood of a recession in the next 1 to 3 years is much higher.

Another thing to keep in mind is that the smart people that work at places like the Federal Reserves and Bank of Canada are constantly looking at these recession indicators. They can then make changes to monetary policy to simulate or cool the market.

By now, you should know that bull and bear markets are cyclical. They come and go. And that over a long period of time, the stock market provides positive returns. If you are in the accumulating phase, a recession may be a good opportunity to add highly discounted assets to your investing portfolio.

Having said all that, although the inverted yield curve has been a good recession indicator, the market behaviour is not constant. Things are constantly changing. So the inverted yield curve may not be a good recession indicator for the next recession.

In the meantime, what should you do as investors?  I believe you should all look at your asset allocation and determine whether you are comfortable with your current allocation and the associated risk level. If you are 99.9% invested in equities, are you going to be able to sleep well at night knowing that there’s a good chance your investments may lose 50% or more of their value? If you are investing 50% in equities and 50% in bonds, are you going to be able to sleep well at night knowing that your returns aren’t going to be as good when the market is firing all its cylinders?  Remember, before you investing in anything, you should be asking yourself the 3 key questions. Look at your investment horizon. Are you tapping into your portfolio within the next 5 years? Or are you going to be investing for the next 30 years? Your investment horizon plays a significant role in how you should allocate your investment assets. Time is your best ally, learn to diversify through time.

For Mrs. T and I, we do not plan to change our investment strategy. We plan to continue saving money each month and use that money to invest in dividend-paying stocks and index ETFs. If the market goes up, great, our portfolio value goes up. If the market goes down, great, we get to buy stocks and ETF’s at a discount. Since we are only in our late 30’s, our investment horizon is quite long. Our goal is to become financially independent through passive income in our early 40’s (mostly through dividend income). Therefore, we don’t plan to tap into our principles. There’s no point freaking out about something (i.e. a recession) that we have absolutely no control over. We can only focus on things that we have control on – our income streams, our expenses, our savings rate, and how we invest.

If you keep worrying about something that you have absolutely no control over, then you won’t be able to sleep at night at all.

Why put you through that kind of hell?

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19 thoughts on “The recession is coming???”

  1. Some countries resp industries have already been hit by a economic slowdown which can easily lead to a recession. Just looking at Germany with its extremely strong auto industry, chemical companies and especially car suppliers have been hit strongly. 3M‘s latest quarter results show some global slowdown.
    Such branches resp companies are kind of indicators for me to get a bit more cautious resp. defensive (keep/build nice cash pile, being more selective with stock buys than usual ). My wife and I are in the accumulation phase, so lower price levels (I am talking about some Euopean sectors) is good news. But as said, we remain cautious, it‘s always possible that stock prices will be cut in half or more and then we want to have a lot of cash, ready to invest heavily.
    Cheers

    Reply
  2. Great summary Tawcan!
    Given the recent rate hike in the US and the hawkish language used by the Feds it will interesting to see what happens to the economy in the next few quarters. The Feds generally has a history of overshooting.
    Although it’s a good thing to be able to buy dividend stocks at a cheaper price it’s tough to see your portfolio drop this much. Controlling emotions is more important during this turmoil.

    Ernest

    Reply
    • It will indeed be interesting to see what happens to the economy in 2019. Feds are in a tough situation, the interest rates are still relatively low, so it might be a good idea to raise interest rates in case a recession hits and the economy needs to be stimulated.

      Reply
  3. Nice summary of how the yield curve inversion works as a leading indicator Tawcan! While it’s true that the odds of a recession are now more likely than the boom continuing, I’m not terribly concerned.

    We’ve got a TON of money in cash, and our financial independence isn’t tied to market based capital appreciation. We’re in good shape to weather an extended bear market.

    Reply
  4. I’ve had recession on the mind for a while and was planning on sitting on a bit more cash than usual but I couldn’t help myself – when the big drop happened yesterday I had to buy more index funds because it was a good $5-10 per share discount. We’ll keep building up cash reserves and buying when the market is dropping as long as we both have decent paying jobs, we won’t have enough to retire in a decade if we don’t take those drops as opportunities.

    Reply
  5. The yield curve hasn’t inverted yet. At least not the 10-2 spread, which is the most widely used one. A more exotic one is the spread between 5 and 3 years has indeed inverted but I have never heard any serious practitioner use that exact definition of the yield for business cycle timing. It’s ALWAYS (!!!) the 10-year at the long end and then we can argue whether we want to use the 2-year or 1-year or Fed Funds Rate at the long end. The only people who look at the 5-3 spread are journalists with no financial knowledge and too much time and nothing else to write about.

    Reply
    • Right, updated the 10-2 spread comment in the thread. I kinda indicated that but not very clear.

      Are you saying that I have no financial knowledge and too much time and nothing else to write about? 🙂 😉

      Reply

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