Adapt Or Die: Prepping For A Recession

by: Dorsey Wright Money Management

Economists are beginning to think that the recent market decline may presage a recession. Most are not convinced, but many are on the cusp. Ed Yardeni has a troubling chart today on unemployment. He writes:

One of my favorite monthly indicators of the labor market is especially disturbing. In its monthly survey of consumer confidence, the Conference Board asks their respondents whether jobs are available, plentiful, or hard to get. The percentage saying that “jobs are hard to get” (JHTG) is highly correlated with the unemployment rate. In August, it increased to 50% from 44.8% in July. Its most recent low was 42.4% during April 2011. So the labor market has actually been deteriorating every month for the past three months, according to this measure. It gets worse: The latest reading is the highest since May 1983. And that’s after the White House spent $880 billion aimed at creating 3.7 million jobs over the past two and a half years. We certainly didn’t get our money’s worth.

The chart that goes along with it is below.

Source: Dr. Ed’s Blog (click on chart to enlarge)

The question before investors is always how to respond to perceived bad news. It’s a complicated problem because it is never clear how much bad news is already baked into the market. One of the typical problems retail investors have is bailing out of markets rife with bad news, having the bad news come out, and then watching the market go up as the market decides the bad news wasn’t quite as bad as it could have been! Sometimes you can make an educated guess when sentiment is at an extreme level, but it’s never precise.

So, simply responding to bad news won’t get you anywhere.

Relative strength is often a productive way to approach this problem. Relative strength lets the market separate the winners from the losers. When the economy weakens or strengthens, companies are affected differentially. New orders may decline at a factory, but the profit margins may increase due to higher productivity with fewer employees or from increased automation. The market is usually pretty good at figuring out where the offsets are—and also where they aren’t.

The point of the game is to adapt. If the securities or asset classes you hold are performing poorly, ditch them. If the replacements perform poorly, ditch them too. Most money is lost stubbornly holding a position while waiting for the market to confirm your personal opinion. When it works, the iconoclasts receive acclaim and media adoration, which might be part of the reason stubbornness is seductive. (That, and not having to admit you were wrong.) But there aren’t enough roses in the world to put on the gravestones of stubborn traders whose opinion didn’t quite work out. Adapt or die.