Let's Talk About The Next Recession: Our Plan Of Action

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Includes: BRK.B, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, IYR, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VNQ, VOO, VTWO, VV
by: Jussi Askola
Summary

Where are we in the cycle?

How are we preparing for an eventual recession?

How will we react when the cycle finally turns south?

Some discussion on our long-term investment targets at "High Yield Landlord."

If you are confused about the future outlook of the economy, then no worries, you are by no means alone. On one hand, we are getting increasingly dovish statements from the Fed and market experts. On the other hand, we just witnessed another surprisingly strong jobs report with +196,000 additional positions during the month of March 2019:

source

The private sector continues to show a lot of strength even as we enter the 11th year to a long cycle. Employers were not fazed by the recent shutdown and by all means, the economy keeps going strong as evidenced by the healthy labor market.

So who are we to listen to?

  • Are we headed toward a recession?
  • Or are we still going strong for quite some time?

We have discussed this topic in depth through our numerous Market Updates at “High Yield Landlord” and we always seem to come to the same conclusion: We expect a deceleration of economic growth, but unlike many others, we believe that this deceleration will be gradual. It takes time to slow down a well-running economic machine, and therefore, we are likely to see another two years of growth before the eventual recession.

Nonetheless, it should be clear to everyone that a recession is coming. That's inevitable. Economies have ALWAYS moved in cycles, and this time won’t be any different.

We do not mean to pointlessly scare you, but we are now in the 11th year of the expansion and unemployment is below 3.9% for the first time since 1969:

Source: Author's picture, Booklet of NREC

  • Such low unemployment rates are commonly achieved toward the very end of a cycle and shortly followed by a downturn.
  • Economic expansions generally last 5 to 10 years and we are now overdue.
  • Almost all market intelligence points out that our current cycle is already stretched and approaching its end. The tight labor market, risk of inflation, trade wars, and growing populism are putting increasing pressure on the current cycle.

Takeaway: A recession is likely to occur in the coming years. It's however not possible to time it perfectly, so what should we do?

Our Plan of Action for the Next Recession

We are strong believers in “time in the market” rather than “timing the market.” Despite what market “experts” will tell you, hopping on and off of stocks has never worked.

When the stock market bottomed in March 2009, news pundits screamed, “It’s dropping another 50%!”

At the best buying opportunity of a generation investors liquidated.

The market rose 10%.

Pundits screamed, “Sucker rally! Get out now!” And investors sold.

The market rose another 10%.

Pundits screamed, “Double dip recession coming. Get out now!” And investors sold.

We’re now ten years into one of the greatest bull markets in history. For 10 years pundits have screamed, “Get out now!” And investors have sold.

When the buying opportunity is greatest the economy and markets look the scariest. And most people freak out and sell.

When questioned why they say, “I’m waiting until it’s safe to get back in.”

So if you can accurately determine when a recession will start. How deep it will go? When it will end? And accurately determine the same thing about the stock market. Then waiting for a recession to invest is a great strategy.

One little nagging problem. No one has ever been able to do that consistently.

One other little nagging problem. In the midst of an economic hurricane most people panic. Very few have the chutzpah to buy.

source

Conclusion: No one has ever managed to time the market consistently. Warren Buffett from Berkshire (NYSE:BRK.A) (BRK.B) is arguably the world’s most successful investors and he has always remained invested in all time periods and laughed at market timers. He invests in every year, good and bad. Recessions and recoveries. Tops and bottoms. True wealth is built day by day. Not by trying to discover the unknowable.

Therefore, our plan of action in the next recession will be very simple:

  • We will remain fully invested. Our investment holdings will temporarily lose value and we are fine with it. Sooner or later, values will recover, and since the timing of this recovery is unpredictable, it's too dangerous to hop on and off of the market.
  • We will use dividend income to reinforce positions while they are offered on the cheap. We expect most of our REITs to continue paying high dividends throughout the downturn. Some will reduce it, but overall, we will continue to generate significant income that we will use to buy more shares.
  • We also will add new cash to our account to increase the size of our REIT portfolio when bargains become abundant. We are today saving up for the next recession. Currently, my personal cash allocation is about 20% of my net worth. Once the market turns south, we will put a big portion of this cash to work when others are desperately selling.

There's no doubt that we will suffer paper losses in a recession. But this should not be a worry to the long-term oriented investor. Rather, we should see it as an “opportunity” to increase the size of our real estate empire on the cheap.

How We Prepare for the Next Recession

In order to take full advantage of the next recession, we are preparing on two main fronts at High Yield Landlord:

#1 - Psychological preparation

We need to accept now that once we hit the recession, the value of our investments will go down. This is inevitable.

If you accept it and understand why we remain invested for the long run, then you will be fine and avoid panic selling. There's nothing more dangerous than making emotional decisions and panic selling at a bottom.

We are well prepared psychologically because we have seen this process happen time and time again:

  1. Markets drop due to fears.
  2. Investors panic and sell.
  3. We buy more.
  4. The market eventually recovers and we are much better off than before the sell off.

We do not expect next time to be any different. And the time after that won’t be either.

#2 - Portfolio preparation

On the portfolio front, we are well prepared and have already adjusted our strategy in expectation of a recession. In total, close to 40% of our real estate portfolio is allocated into defensive sectors including storage, healthcare and net lease.

  • Self-Storage: Demand is very inelastic to economic conditions. In fact, in a recession, the demand may even go up as people downside to smaller homes and need storage space for all the extra stuff.
  • Healthcare: Similarly, the demand drivers do not change materially in a recession. People will still get sick and need medical facilities to get treated.
  • Net lease: The strength of net lease properties is mostly in the exceptionally long lease terms of up to 10-15 years that protect the landlord in a recession.

Source: High Yield Landlord Real Money Portfolio

To target even greater downside protection, we chose to follow a "value" approach - seeking to invest in REITs trading at low valuations and higher dividend yields that are backed by low payout ratios.

Core Portfolio Analytics:

Source: High Yield Landlord Real Money Portfolio

In this sense, we do not rely on aggressive growth assumptions to generate attractive total returns. Our holdings are valued at just 9.4x FFO with pessimistic assumptions of zero to little growth going forward. We believe that the "already" negative market sentiment may help us to reduce downside in the next market downturn since the valuations already are at relatively low levels today.

Moreover, since our average dividend yield is a hefty 7.8% - backed by a safe 73% payout ratio, we expect the majority of our dividend income to remain sustainable even in a recession. Generating returns through high dividends feels much safer at this point of the cycle rather than targeting more appreciation in a potentially stretched marketplace.

Bottom Line:

Sooner or later, we will go into a recession and the stock market will drop significantly. Now that you know our plan of action for the next recession, you can prepare for it psychologically and economically. We will not sell. Instead, we will hold on to our property investments and hope to buy much more while prices are cheap.

If we are still not convinced by our plan of action, we invite you to read some of our favorite quotes from legendary investor Warren Buffett:

“We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

“Over the long term, the stock market news will be good. In the 20th Century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a fly epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

“Buy a stock the way you would buy a house. Understand and like it such that you’d be content to own it in the absence of any market.”

In this sense, we like to think of ourselves as property "landlords," rather than stock market traders at High Yield Landlord. By accepting the inevitable short-term (paper) losses of a recession and taking a long-term mindset, we will emerge much stronger from the next recession.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.