October was a painful month for stock investors! The S&P 500 stock index dropped 6.8 percent for the month with international stocks faring even worse, down more than 8 percent. These sharp, negative moves sparked many conversations about a coming recession. Should you sell now?
We have had a nine-year-plus bull market! This has allowed many investment portfolios to experience tremendous growth. However, during this time, we have also heard many calls for an "impending recession." There is no doubt that such predictions will continue. And, eventually, someone will be right. But when is anyone’s guess. What’s the best strategy for your portfolio?
Why Recessions Are Hard to Predict
There is a reason it is practically impossible to accurately predict a recession. The most reliable data for analyzing the economy is backward looking. Backward-looking data reflects history, i.e. actions that have already happened. So, generally, once the historical data indicates a recession, the economy is already well into it.
Will Your Stocks Take a Dive During a Recession?
Not necessarily! The U.S. has gone through nine recessions since 1957, and the S&P 500 returns during those periods have been a mixed bag. In four out of the nine recessions, the S&P 500 actually achieved positive returns. However, overall, during those nine recessions, the S&P 500 was negative with some pretty wide variances in returns. However, most of us remember the last recession in 2008 when the S&P 500 lost more than 35 percent. That one’s pretty hard to forget!
But ditching your stocks too early can be costly. Here’s why. During the last nine recessions, the S&P was up six times for the 12 months leading up to a recession. In some instances, the S&P 500 was up double digits in the preceding 12-month period. So, selling out too early in anticipation of a recession, may cause you to miss a significant upswing.
So What Can You Do?
Since you can’t predict a recession with pinpoint precision, the next best alternative is to be prepared for one.
Dry Powder Strategy: This is when an investor holds cash waiting for the stock market to go down. When this opportunity presents itself (as it may during a recession), the investor buys into the stock market. The investor then waits for the value to increase to its prior level or above. Don’t have a bundle of cash to dedicate as dry powder? No problem. You have another option.
Re-Balancing Strategy: Simply maintaining a balanced portfolio of stocks and bonds can provide you with an alternative safeguard. The bond portion of your portfolio is generally considered a safer investment during a recession, i.e. bonds are less likely to significantly drop in value as compared to stocks. Once an investor has appropriately allocated a portfolio for his/her situation, then rebalancing to maintain that allocation between stocks and bonds is an appropriate strategy to implement during a recession.
Rebalancing your portfolio after big, negative moves in the stock market allows you to harvest returns from investments that have done well (at least on a relative basis) and reinvest them in investments that have not performed as well. Having the discipline to rebalance a portfolio forces the practice of "buying low and selling high."
Does rebalancing work? Yes. Based upon the last nine recession periods mentioned above, the S&P 500 averaged a total return of over 40 percent for the three years after a recession. If you bump that out to five years, the average return goes to over 78 percent. In all nine of those periods, the S&P 500 was positive in the three- and five-year periods after a recession. While there are no guarantees in investing, having this much data on your side should be encouraging!
Like it or not, recessions are part of the investing process. There’s no way to avoid them. The best defense is a good offense. Make sure your portfolio is allocated appropriately, so when the next recession does come – and it will – you can seize the opportunity to rebalance and buy low.
Ryan Collier is Director of Investment Management for Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit the Bedel Financial website at bedelfinancial.com or email Ryan.