How To Profit From The Upcoming Recession

by: Martin Schwoerer

Summary

The next recession may well cause a doozy of a bear market.

You might consider "rotating" into "safer haven" ETFs when the going gets rough.

This worked well in the years 2000-04, as well as in 2008-09.

The ETF version of this strategy achieved a (backtested) return of 24.5% in 2008. YTD (to the end of August 2018), this strategy has returned 8.52%.

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Is a recession on the horizon? And if so, what to do?

These are not trivial questions. When the recession comes, it will hurt people who own stocks. As Kostohryz and many others have said, the difference between a stock market correction and a bear market is that the latter is usually accompanied by a recession.

And the next bear market might well have sharp claws, and be very hungry. Are you OK with the idea of a drawdown in the vicinity of -20% to -63%?

There are several reasons to believe in a soon-coming recession. It's overdue; the yield curve is flattening and inflationary pressures (code words: Trumpism/straw fire) that are appearing need to be addressed, but will be difficult to address lightly.

There are, however, also some good reasons to think everything will continue to be fine: the economy looks hunky-dory, there are no real bubbles to be seen, leading economic indicators such as those amalgamated into Fred Piard's MTS10 are still very positive, and Australia hasn't had a recession in 26 years. If America Is Great Again, then why can't it Beat Down Under?

You might want to base your investment strategy on a philosophy of "everything will probably turn out OK in the long run." But remember how Keynes said that, in the long run, we'll all be dead. I prefer to look for strategies that diminish a recessionary drawdown. Or, better still, I like investment strategies that enable you to profit from a bear market.

Here's one I like. It is basically a momentum/rotational strategy, which invests in certain asset classes depending upon which ones have been working well in the past few months. You don't have to be a charter member of the Church of What's Happening Now to like this kind of approach since numerous studies show that the phenomenon of "Momentum" has worked well over the past few decades/centuries.

My strategy is always invested equally in three of these six asset classes: the SPDR S&P 500 Trust ETF (SPY), the Invesco QQQ ETF (NASDAQ:QQQ), the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF), the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), the SPDR Gold Trust ETF (NYSEARCA:GLD), and the ProShares Short S&P 500 ETF (NYSEARCA:SH). (In layman's terms: the broad equivalent of the U.S. stock market, the Nasdaq, midterm U.S. treasuries, long-term U.S. treasuries, gold, and the inverse of the U.S. stock market.)

It's easy to understand why one would be invested in the SPY and QQQ: both work well in good years. Gold is easy to see too, as it is popular in times of crucial market stress.

SH is fairly self-explanatory; it's quite nice to own something that rises when the market is going down.

But what's the deal with the bond funds, TLT and IEF? My rationale is that TLT has been a wonderful investment over the past two decades, but it is too reliant on deflationary conditions for it to be a guarantor of future performance. IEF, however, is a relatively safe haven even when interest rates are rising.

The look-back period is six months; your investment is reallocated every month according to relative strength.

Performance since 2007 is quite satisfactory, with a MAR of 1.35 to date (end of August 2018).

The details, courtesy of Portfoliovisualizer.com: CAGR = 12.51%; the maximum drawdown is -9.26%, the worst year (2015) was -2.48%. Sharpe = 1.24; Sortino = 2.57. I like this strategy's low correlation to the U.S. market, of only 0.11.

Source: Created by the author using data from Portfoliovizualizer.com.

I think that's pretty OK when you consider that this is an un-leveraged strategy. Why never be invested in a leveraged ETF, such as the Direxion Daily S&P 500 Bull 3x Shares ETF (NYSEARCA:SPXL)? The answer is very simple: I tested it, but it just didn't improve the performance. Why? Beats me!

How was this strategy invested during the crucial months of the Great Recession? During September 2008 - the month Lehmann went bankrupt - we were invested equally in SH and in TLT, and surprisingly, also in QQQ. It lost 2.11% during this month, but rebounded by 18.03% over the following five months, in which we were invested in IEF, SH, and TLT. (This will peeve the gold bugs, I'm sure.)

If you wish to replicate my data, you can do so here. So far, so good, but I can already hear the dividend-growth folks saying: 10 year's worth of performance data is practically useless!

I'd never be so audacious to hope I could convince a DiGro (dividend-growth) guy of anything at all, but just to satisfy my own curiosity, I tested this strategy using good old funds that have been on the market for longer than the above ETFs.

So, I used SPY, Vanguard Intermediate Term Treasury Fund (MUTF:VFITX), Vanguard Long Term Treasury Fund (MUTF:VUSTX), Fidelity Select Technology Portfolio (MUTF:FSPTX), and Rydex Inverse S&P 500 Strategy Fund (MUTF:RYURX). I also inputted Portfoliovisualizer's proxy of gold, which is called "^GOLD."

Performance is now since 1995 - i.e., 22 years and running, and has also been pretty OK with a CAGR of 12.78%. The maximum drawdown is -12.38%, the worst year (2015) was -6.64%, Sharpe = 0.97; Sortino = 1.77. U.S. market correlation: 0.26.

Source: Created by the author using data from Portfoliovizualizer.com.

Over this long time span, MAR has degraded, as these things tend to do, down to 1.03. Still good enough for me!

Here is a link to this version of the strategy as well. How did all this work out during the financial crisis? Well, the ETF version returned a nifty 24.5% in 2008, while the fund version wasn't too flabby either, returning 17.41%.

What about 2018 year-to-date (end of August)? ETF version: 8.52%; fund version: 7.81%.

What never ceases to surprise/irk me with this kind of strategy is how badly it worked during 2015, aka the Year of Toxic Indecision. Trendless "sawtooth" markets that can't make up their minds are a real pain.

Luckily, as Chris Ciovacco has often said, markets trend two-thirds of the time, so as long as this is still valid, we'll be fine. The trend can really be your friend, even after the bend in the end.

I happen to believe in William Zinsser's maxim: if you really want to learn something, then there is no better way than to write about it.

Even more importantly, I hope to profit from your feedback. Did I overlook something? Is dividend-growth investing really better after all? (Just joking!) Looking forward to your comments!

Disclosure: I am/we are long SPY, QQQ, IEF, TLT, GLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.