In a note to clients this week, Deutsche Bank analysts wrote that they expect a “major recession.” Are you wondering what to make of ominous predictions like this? Below are some suggestions.
First, don’t panic. Yes, Deutsche Bank is a big institution. But it’s worth noting that this week two similarly prominent institutions also weighed in—with conflicting points of view. Goldman Sachs argued that a recession is “not inevitable.” And UBS wrote that, “we do not expect a recession.” They can’t all be right.
The reality is that no one can forecast where the economy’s headed. Indeed, there’s an old joke that economists have predicted 19 of the last 15 recessions. But it’s not a joke. An analysis by the International Monetary Fund looked at thousands of forecasts across dozens of countries and confirmed that forecasters, on average, have a poor track record. To be sure, I also worry about the economy, given the inflation we’ve been seeing. But still, nothing should ever be viewed as a certainty.
The second thing to keep in mind: Recessions are a fact of life as an investor. We just don’t know when they’ll occur. Therefore, the best approach, in my opinion, is to be prepared at all times. You can do that by paying close attention to the asset allocation in your portfolio. The key is to have enough funds outside of the stock market to carry you through a typical stock market downturn, which might last up to five years. Suppose, for example, you depend on your portfolio for withdrawals of $100,000 per year. Then I would recommend holding at least $500,000 in some combination of cash and conservative bonds. For that reason, I would take time to review your portfolio’s allocation.
If your portfolio is structured in this way, you will, I think, greatly reduce the likelihood you’d need to sell any of your stock market holdings at the worst possible time—when they’re down. Just as importantly, this structure can help you sleep at night. If you know that a recession could occur at any time, but you also know that you’d be well prepared to weather it, then you need not worry—and need not react—when one actually does arrive.
I recommend this approach in contrast to the more traditional way of thinking about portfolio risk management, which relies on “risk scores.” Many brokers, for example, use a scale from 1 to 10. Nervous investors are assigned a score of 1 and are set up with portfolios of only cash and bonds. Aggressive investors—the 10s—are invested entirely in stocks. Everyone in between is invested in some mix of the two.
On the surface, this might sound reasonable. The problem, though, is that it takes into account only the investor’s attitude toward risk and not their actual financial needs. That’s a problem because the two aren’t necessarily the same. Whether someone is cautious or aggressive by nature isn’t necessarily related to that person’s financial situation. So as you set your asset allocation, consider both your financial needs and your mindset. Ignoring either could be problematic in a market downturn.
One of the scary things about market downturns is that it’s often hard to imagine when or how they’ll end. We saw that most recently in 2020. No one knew how quickly vaccines might be developed or how effective they would be. But as with each prior downturn, the stock market recovered and ultimately went higher.
As the standard investment disclaimer goes, though, past performance is not a guarantee of future results. So how can you be confident that the market will, in fact, recover from the next downturn? Specifically, how can you know that you’ll be in good shape if you’ve set aside the five years of portfolio withdrawals that I’ve recommended? While nothing in the investment world should ever be considered a certainty, there’s a logical reason we should expect the stock market to deliver positive returns over time.
That reason is because stock prices—on average, over time—follow the profits of the underlying companies. Of course, there are always exceptions. But if you took a chart of the stock market and then overlaid a chart of aggregate corporate earnings, you would see a close correlation. The stock market, in other words, goes up for a reason. If corporate earnings continue to grow in the future, we should expect the stock market to rise as well.
To take that a step further, are corporate profits guaranteed to rise over time? Again, there are no guarantees, but there are reasons to expect that to be the case. The most basic building block is population growth. Even if companies did nothing different from year to year, their customer bases would expand. They would then sell more and see their profits rise.
Another reason we should expect corporate profits to rise: Innovation. Consider a company like Microsoft. Last year, it brought in more than $60 billion from cloud-based software—a business that barely existed twenty years ago.
A related concept is productivity. Corporate profits grow because companies, on average, get more efficient each year. Thus, even if sales don’t increase, a company could still see its bottom line increase.
Corporate profits grow also because of price increases. Colgate-Palmolive provides a good example. Last year, the company’s volume increased just 1%. That means the number of tubes of toothpaste and bars of soap it sold grew by just 1%. However, the company was able to raise prices by 3.5%. As a result, revenue grew 4.5%. Together with a few other factors, Colgate’s earnings per share grew nearly 5%—even though the volume of products it sold grew just 1%. This might seem like sorcery, but it’s very common.
Taken together, these are the reasons why I have confidence that stock prices will grow over time. Of course, the market doesn’t move in a straight line. And that’s why you should always have funds set aside to deal with the inevitable ups and downs. But if you do, then I see no reason you should fret when the prognosticators on Wall Street start reading from their tarot cards.