Recession Obsession

The two most painful characteristics of recessions are that workers lose their jobs and risk assets lose value.


Our Top Market Takeaways for the week ending August 23, 2019.

What happened while I was on vacation?

Despite more trade noise this morning, the S&P 500 ought to end up more or less flat after one of the slowest weeks this year (by equity trading volume). Although markets haven’t moved too much, the mood seems to have changed. I took a few days off last week to spend some time with family, and when I got back, everyone was obsessed with “recession.” What happened?!


I should have sensed that something was weird. Even my family started asking me questions about “the yield curve” and “jobless claims” and “bear markets.” I refused to answer then, but, to make it up to them, I wrote the below responses to some FAQs.

What is a recession anyway?

This is one that is trickier than you might think. The definition that most know is a “technical recession”: two back-to-back quarters of negative year-on-year growth. This one is easy because it is standard and objective. You can also apply this to anything: Earnings can be in recession, manufacturing can be in recession, Italy seems to always be in recession, my golf game is in recession, etc.

The problem is that most people in the United States (whether they realize it or not) actually rely on the National Bureau of Economic Research’s definition of recession. The NBER's is much more subjective :

“The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic 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.” 

The important takeaway is that you don’t need negative growth to have a recession. The 2001 recession is a good example. Even in the worst quarter (Q4 2001), GDP managed to eke out a +0.15% year-on-year gain.

Another thing to note about the NBER: It takes its sweet time in defining when a recession started. For example, it didn’t announce that the last cycle had peaked until December 2008, after J.P. Morgan bought Bear Stearns, Lehman Brothers failed, Fannie Mae and Freddie Mac had been put into conservatorship, and -40% losses for S&P 500 investors. It didn’t do any better on the other side, either. It “called” the trough 14 months after it happened, and 18 months after the market bottomed.

So, why do we all care so much about when a recession will come?

The two most painful characteristics of recessions are that workers lose their jobs and risk assets lose value because earnings expectations come down and risk appetite wanes. When you consider the extent to which most Americans’ retirement savings are invested in the stock market, this combination has real human costs.

Since the end of World War II, there have been 11 recessions in the United States and, spoiler alert, the stock market has sold off meaningfully in all of them. The average peak-to-trough decline has been -30%. The two worst are also the two most recent examples. During the Financial Crisis (or Great Recession), the S&P sold off by -57%. The Tech Bubble was associated with a -49% decline.

However, a recession does not guarantee a bear market, nor does “not recession” guarantee no bear market. Reminder: A bear market is a stock market decline of -20% or more. The recession of 1960–61 was only associated with a -14% drawdown, while the U.S. Steel episode of 1962, the 1966 bear market,* the 1987 flash crash, and the Christmas sell-off of 2018 all saw -20% drawdowns without a recession.**  

Why is everyone getting worried?

You can stop reading if you’ve heard this before. Manufacturing and trade data has been very weak and continues to surprise to the downside, and the trade war between the world’s two largest economies has everyone on edge. The recent development is that the U.S. 2-year–10-year Treasury yield curve briefly inverted, and that signal has entered the zeitgeist. Even the White House has reportedly considered cutting payroll taxes to stimulate things. This all seems like overkill when you consider that the Atlanta Fed estimates that the economy is growing at an over 2% annualized rate.

Why the disconnect?

This seems rooted in something that we write about often: Data releases and market pricing tend to put more weight on the manufacturing sector relative to its actual importance to the whole economy.

Goods-producing industries (manufacturing, mining, construction, etc.) make up 17% of gross-value added to the economy, while services (wholesale and retail trade, information, finance, healthcare, food services, etc.) make up almost 70%. The issue for investors is that stock markets often have more representation from the manufacturing side than the economy does in aggregate. This helps to explain why, despite decent absolute growth, the S&P 500 has only managed a +3% price return after manufacturing PMIs (one of our favorite growth gauges) peaked globally in January 2018.

The good news is that the U.S. consumer still seems healthy, and the labor market has shown little signs of cracking despite disruptions in manufacturing and trade. Financial conditions aren’t too restrictive after the Fed pivot, and there is no obvious economic imbalance that seems on the brink of unwind. Therefore, recession isn’t in our base case for the near term.

What should investors consider doing?            

For those already invested, we’ve advocated for (and enacted in portfolios that we manage) a more balanced approach relative to longer-term, strategic allocations. It seems clear that it is late in the cycle, and accidents can happen when the Fed has tightened policy and growth has slowed down. There doesn’t seem to be too much to gain by being overly exposed in any direction.

For investors looking for new opportunities, there are plenty. In equities, high-dividend stocks are trading at their largest valuation discount since 2000, and higher volatility can create opportunities to harvest yield. Real estate could also offer a diversified source of income. Sectors that are growing may be worth paying more for, as the digital evolution should continue to generate returns for investors. Finally, if we are wrong, and there does turn out to be a recession in the near term, core fixed income and gold ought to offer protection to portfolios.

*It’s unclear what caused it, so no nickname ¯\_(ツ)_/¯.

**Unless the NBER decides that we were already in one at some point in the future. 

All market and economic data as of August 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

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