Some financial analysts are saying there could be a recession coming. And that's not necessarily a bad thing.
The word "recession" strikes fear into most investors' hearts. But while asset values typically drop during a recession, downturns are actually a healthy and necessary part of the economy, clearing weaker areas to usher in a new era of growth. To understand this, consider the analogy of wildfires (recessions) in a forest (the economy).
The Economy is an Ecosystem
In a forest, small periodic fires clear the most flammable material. This natural process inherently inhibits massive fires because it prevents a large buildup of dry, combustible brush and fallen trees. Similarly, as Nassim Taleb writes in Antifragile:
"Stability is not good for the economy: firms become very weak during long periods of steady prosperity devoid of setbacks, and hidden vulnerabilities accumulate silently under the surface…The longer one goes without a market trauma, the worse the damage when commotion occurs."
As with most areas of investing, there is tension between what the investor desires and what the market needs. From an emotional perspective, investors seek stability; however, even as it is nerve-wracking, a healthy amount of volatility is actually essential for long-term economic strength. The constant smaller "fires" are what discipline an economy into being strong and vibrant. Recessions: create fear and thus low prices on investment assets; "stress test" what's been built over the previous expansion; and bankrupt weaker players in the economy, "clearing the brush" for further growth.
When it comes to forests, we have already learned the consequences of preventing the natural, smaller wildfires. In 1988, nearly one-third of Yellowstone National Park burned or was damaged in a massive fire, the size and ferocity of which stemmed from wildfire suppression efforts. Today, we do not try to prevent every forest fire, but we still try to stave off every little downturn.
Letting Nature Take Its Course
What our firefighters have already learned, our central bankers have yet to embrace. We see them using "volatility suppression" tools like QE programs and extremely low interest rates to artificially forestall inevitable economic forces. But the concept of "fail early and fail small" is a universal paradigm discussed in many disciplines. As fund manager Ray Dalio likes to state, pain plus reflection equals progress. When there is no (hopefully smaller, short-term) pain, there is no reflection, and all dubious current practices are allowed to continue.
While I'm critical of central bankers for using powerful tools to push off the next downturn, it's easy to empathize with the "why" of what they do. First, these are all smart people who are obliged to "do something" when problems arise. A central banker who, in the midst of economic turbulence, says, "we just have to let the system fix itself," would get quickly escorted out of policy making.
Second, sitting idle when a downturn starts inflicts pain (in the short term) on the citizens one is supposed to be helping, which can be unpalatable. After all, even as recessions are healthy economically and provide investment opportunities, they are also usually accompanied with humanitarian pain.
Third, aggressive monetary policy tactics globally have the implicit goal of making a country's currency more competitive. Since central bankers the world over are beholden to this competition, there is no off-ramp where a lighter-touch policy by one country doesn't also make it suffer disproportionally more than countries continuing full-speed ahead. Avoiding this would require all central bankers to simultaneously take a less interventionist mentality, which will never happen.
There is a place for firefighters, but we need them to be more humble and have more respect for the ecosystem. We need all stakeholders in the economy to trust that capitalism will work, warts and all. It is not a perfect system, but like Churchill said about democracy, "it's the worst system save all the others."
Lessons and Opportunities
Through the extreme policies of central banks during the last few years, many silly and unsustainable practices have been enabled. Since no one can time a recession, prophecy must be replaced with patience and discipline. In his latest shareholder letter, Warren Buffett cites "Noah's law," which goes: "If an ark may be essential for survival, begin building it today, no matter how cloudless the skies appear."
In that spirit, here are a few considerations for your portfolio in advance of the next recession, whenever it arrives:
- Have higher than average liquid assets in your portfolio. This will not only buffer your losses during the downturn but also give you more "dry powder" to invest when lower prices arrive.
- If you're living off your portfolio, have a larger than average cash buffer.
- Favor companies that are self-funding and don't depend on the capital markets for survival.
- Favor companies whose products are still bought during severe recessions.
- Favor companies who have pricing power in case all these extreme policies lead to inflation.
Recessions enable a complex system to heal itself from unhealthy practices of previous expansion. From an investment perspective, one should have more confidence once the healing has begun. The news will be worse and the economy will be trending down, but security prices will be lower and healthy business practices will rise. And when the smoke clears (as it always does), the forest will still be standing, primed for another period of growth.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.