Recession chatter is growing in the air, so this article takes a look at some bull and bear arguments regarding a potential recession, and what we can possibly do about it if there is one coming.
A year ago I initiated a real-money model portfolio on my website, and I am posting it here on Seeking Alpha as well so that we can track it together. It outperformed by a significant margin so far, but it's important not to get complacent and stick to what has worked. It's often the case that what does well in one time period does poorly in the next time period, so this article focuses on why assets that performed well over the past decade are unlikely to be the top performers over the next decade.
The Mighty Yield Curve
The big news over the past month has been that the yield on the 10-year U.S. Treasury note keeps touching below the 2-year U.S. Treasury note, which is a well-known recession indicator. It’s unusual for long-term bonds to pay lower yields than short-term bonds, and it usually happens in the year or two leading up to a recession, as the bond market expects the Federal Reserve to cut short-term interest rates.
This chart shows the 10-year yield minus the 2-year yield (blue line) along with the Wilshire U.S. stock market price index (red line), with recessions shaded in gray:
Chart Source: St. Louis Fed
Clearly, that’s not great to see.
However, other portions of the yield curve have already been inverted for quite some time, and this is not some definitive recession metric.
The yield curve, for example, has not quite been as reliable at predicting recessions in other countries as it has been in the United States, although a flattening/inverting yield curve is nearly universally associated with a slowing economy, whether it dips into outright recession or not.
The main question is whether this is merely another slowdown along the way towards further expansion (which is what happened in 2012 and 2016, except without the inverted yield curve), or if this is the end of the decade-long U.S. expansionary business cycle into an official recession where unemployment increases, companies are forced to deleverage, GDP growth goes negative for at least a couple quarters, and so forth.
The bull case argument is that the decelerating growth that we’re experiencing is mainly due to trade war uncertainty and supply chain management. Businesses won’t invest as much until they get some clarity, one way or another, about the trade dispute between China and the United States. If that’s the case, growth may be able to resume if some level of agreement is reached.
The bear case argument is that the trade war is just a catalyst and that declining growth rates are deeper than that due to debt, demographics, the natural exhaustion of the business cycle, Chinese deleveraging, and other factors, and that the economy needs a recession to clean out mal-investments and force companies to deleverage. After all, this has already been the longest period in U.S. history without a recession.
The bond market, which is pushing down interest rates and inverting the yield curve, seems to think a recession is coming. The copper market, which is a strong historical indicator of global economic growth, seems to agree with the bond market, as prices have fallen by over 20% during the past 18 months.
The equity market as a whole still seems to think otherwise, and is hanging out near all-time highs, but is starting to get more volatile. However, the stock market internals, meaning the divergence between types of stocks within the market, are also showing heightened risk of a recession. Specifically, cyclicals and small-caps are in a bear market while many large defensive stocks like utilities and consumer staples are spiking upward.
Economic Indicators: Rate of Change vs. Absolute Levels
The recession debate in the financial media these days is confusing for a lot of people, because employment levels are still good, and many areas in the economy are at all time highs. How could we be talking about a potential recession?
The key is to remember that a recession is merely a contraction from all-time highs. It’s the rate of change that matters, so when growth levels start to decelerate it’s an orange warning light, and when they start to contract with negative year-over-year growth, it’s a more serious red light.
Most measures of economic activity are still at high levels. For example, annual U.S. construction spending looks pretty good since the last recession, with recessions shaded in gray:
Chart Source: St. Louis Fed
However, the “percent change from a year ago” measure for total U.S. construction spending looks a lot less rosy, as it is just beginning to enter a contraction from its current high point after several years of continuous expansion:
Chart Source: St. Louis Fed
We’re seeing the same thing for many other indicators, such as PMI, capital goods orders, and so forth, although they have been more cyclical in general. For example, here is the rate of change of U.S. industrial production:
Chart Source: St. Louis Fed
The United States had an industrial production contraction in 2016 when China’s economic growth and commodity consumption slowed down, and global oil prices crashed. However, due to global monetary and fiscal stimulus and other factors, the production picked up and resumed growth without a full recession. Currently, we seem to be headed for another contraction in this indicator or at least close to one, and time will tell how this plays out.
The Ultimate Factor
The U.S. manufacturing and construction sectors are already in a mild downturn based on broad economic data, but manufacturing and construction are relatively small parts of the U.S. economy. The healthcare and software industries, for example, are not currently in a contraction.
More importantly, consumer spending represents over two-thirds of U.S. GDP. That’s the ultimate factor: as goes the consumer, so goes the economy as a whole. Year-over-year consumer spending is still strong:
Chart Source: St. Louis Fed
And the year-over-year increases in employed people (blue area) is still higher than population growth (red area):
Chart Source: St. Louis Fed
Unemployment and spending tend to be lagging indicators, as the more cyclical parts of the economy tend to turn down first, followed by job losses and spending decreases. However, weakening cyclical sectors were not enough to pull down employment and consumer spending during the U.S. economic slowdowns in 2012 or 2016, so we’ll see if 2020 is the third strike for an actual recession or not.
Compared to the previous U.S. slowdown in 2016, we have a few more bearish factors this time around, such as an inverted yield curve, the beginning of a contraction in domestic construction spending, and higher consumer credit levels.
Sometimes readers email me about my thoughts on going all to cash, or tell me that they've been in cash for a while and are "waiting for the next crash" to invest. I don’t give personalized investment advice, but speaking for myself, I don’t use an “all or nothing” approach like that, and instead I dial my aggressive or defensive positioning based on valuations and economic cycles, without trying to time things precisely. I am rather defensively positioned at the moment for my age, but for me that includes a diversified set of assets including stocks, bonds, precious metals, real estate, and so forth.
Basically, I never make a bet that “the market is going to do this.” Instead, I gradually shift my aggressiveness or defensiveness around based on probability distributions of forward returns from various asset classes. My portfolio review down below shows how well this can work when we have a market drop, like we did late last year.
Look Forward, Not Backward
Over the past decade, the United States has been the best-performing major stock market by a wide margin. The question is, will it be one of the best performing in the next decade as well?
Ray Dalio, the founder of Bridgewater Associates, published a detailed report called “Paradigm Shifts” last month that analyzed the past century of investment returns in the United States and concluded that the best-performing asset classes in any given decade tend to underperform in the following decade. Stocks do well one decade, and bad the next. Bonds do well one decade, and bad the next. Precious metals do well one decade, and bad the next.
While investing is never easy, it’s not rocket science to see why that happens. The worst-performing decades for stocks tend to come after their peaks of high valuation. Bonds outperform in periods of declining inflation, and underperform when inflation picks up. Gold and silver go nowhere for a decade or two until they are forgotten and ridiculously cheap, and then inflation or unusual monetary policy wakes up investor interest in them and they outperform everything for a time.
This phenomenon tends to occur internationally as well. The following chart by Star Capital shows that there is almost a perfect inverse correlation between the best-performing stock markets of this current decade and the best-performing stock markets of the prior decade:
Chart Source: Norbert Keimling, Star Capital
After such a strong decade, the U.S. stock market is now one of the most expensive in the world. It’s the place everyone wants to be invested in.
Back to Dalio’s article on paradigm shifts, he analyzes some of the reasons why the U.S. market has done so well. During the past two decades, U.S. corporate profit margins have nearly doubled from 8% to 15%, and employee compensation dropped from 76% of revenue to 68% of revenue. The effective corporate tax rate decreased substantially thanks to the 2017 corporate tax cuts.
He breaks U.S. market performance down layer by layer, like an onion. In the following chart, the blue line represents the U.S. stock market actual performance. The red line shows what it would have been without valuation increases related to declining discount rates. The orange line shows what it would have been without profit margin increases. And the gray line factors out the impact of 2017’s corporate tax cuts:
Chart Source: Ray Dalio, Bridgewater Associates
The reason it is worth splitting these layers open is because most of them are very unlikely to be repeated over the next decade, and might even reverse. Profit margins are unlikely to expand from 15% to 20%, for example, and might move closer back towards 10%-12% historical levels. Corporate tax cuts are unlikely to be repeated at this scale, and depending on election outcomes, might be reversed to higher tax levels.
Record corporate debt as a percentage of GDP, thanks to historically low interest rates, have allowed corporations to issue bonds to buy back shares, which boosts earnings-per-share growth. This is fine when done sustainably by high-quality companies out of actual excess free cash flow. But when taken as a whole, this is unsustainable for the broad market to continue forever at recent levels. As of the most recent quarter, stock buybacks are already slowing down.
Since the previous business cycle peak in 2007 until today, S&P 500 revenue (actual top-line growth) has increased by less than 30% while S&P stock prices have gone up about 100% thanks to higher valuations, higher profit margins, tax cuts, and record levels of stock buybacks.
When most of those layers are factored out (resulting in the gray or dotted blue lines on the above chart), U.S. stock market performance over the past quarter century looks about the same as the actual European stock performance over the same period, because Europe didn’t have most of those layers added into their market:
Chart Source: MarketWatch
Investors have a habit of assuming that whatever has outperformed recently will continue outperforming, despite decades of worldwide evidence to the contrary. “It’s different this time,” they tend to think.
It’s hard to say for sure what asset types or regions will perform the best going forward, but we do at least have some tools available to us, like looking at the core engine of growth rates and valuation changes, along with the “layers” that we expect to be added or subtracted from that core engine of growth and valuation.
U.S. Economic Strength
It’s a common theme among bulls and bears alike to say that the U.S. economy is stronger than the rest of the world. Bulls say the U.S. economy is great and better than most other places. Bears say the U.S. economy is weakening and probably entering recession, but at least better than most other places.
This is certainly true on the surface. The United States has had higher GDP growth than other developed markets like Europe and Japan over the past decade, mainly thanks to a slightly younger and faster-growing population as well as innovation out of Silicon Valley. The U.S. Federal Reserve was able to begin normalizing monetary policy with positive interest rates and mild reductions of the Fed’s balance sheet, while the central banks of Europe and Japan remain at zero interest rates and were never able to begin decreasing their balance sheet.
Going deeper, we must ask if demographics and tech culture are the only reasons for recent U.S. economic outperformance, or if there are other reasons. Fiscal policy has been an obvious difference, and worth noting.
I put together this chart of the fiscal deficits and the current account deficits (as a % of GDP) of major developed countries and the emerging BRIC countries over the most recent full year (2018):
Data Source: Trading Economics
The fiscal portion (orange line) measures whether the government is operating at a big deficit to try to pump up growth or whether it is being more austere with a surplus. Countries that run higher deficits may be able to boost growth for a time, but eventually it catches up to them like a hangover.
The current account (blue line) includes the trade balance as well as income transfers into and out of that nation. A nation with a current account surplus basically produces more than it consumes, and a nation with a big current account deficit consumes more than it produces.
Over time, a nation with many years of current account surplus will find itself with a strong net international investment position, meaning it owns a lot of international assets. A nation with many years of current account deficits will find itself with a negative net international position, meaning that foreigners own a lot of its assets.
Japan has a significant fiscal deficit, but has a positive current account. The population is shrinking and aging due to demographic headwinds, but due to decades of hard work and strong growth, they’re like a retiree living off of dividends that they invested throughout the world. At +$3 trillion, they have by far the world’s largest absolute net international investment position, and one of the highest when ranked as a percentage of GDP.
The Euro Area has a strongly positive current account and a very small fiscal deficit. Looking into the top three economies in the region (Germany, France, and Italy) shows that Germany (the largest economy in Europe) has a surplus in both areas, Italy has a strong current account surplus and a moderate fiscal deficit, and France has a relatively flat current account and a moderate fiscal deficit. Overall, not bad based on these metrics.
The United States and United Kingdom are the worst on the list in terms of developed countries. The United States has a fiscal deficit as bad as Japan, but also has a significant current account deficit. The UK has a slightly less bad fiscal deficit, but an even worse current account deficit. The United States has the world’s most negative net international investment position, and worse than most other major countries as a percentage of GDP, due to decades of structural trade deficits.
Emerging markets vary. Russia has a surplus in both areas, thanks in part to oil, gas, and other natural resources. It is building up huge financial reserves relative to its GDP and money supply. China has a flattish current account but significant fiscal deficits. India has deficits in both areas, partly due to its reliance on oil imports. Brazil is flattish for its current account but has major fiscal deficits as it emerges from recession and reforms its government.
And this isn’t a one-year phenomenon. For the first time in the modern era, in 2018 and 2019 the United States has an increasing federal budget deficit during a period of low unemployment and strong economic growth outside of wartime. This is a major deviation from 70 years of U.S. fiscal policy:
Chart Source: Goldman Sachs, Retrieved from CNBC
Basically, the United States has the best developed world economy in terms of growth, but under the surface is more reliant on government deficits and trade imbalances than most of its peers. Germany, for example, has reduced its government debt as a percentage of GDP from 80% to 60% over the past decade while the United States has increased its own government debt from 90% to 105% of GDP.
Basically, Americans are pressing the fiscal stimulus pedal nearly to the floor and speeding, while Germans are driving their car slower than the speed limit, for better or worse. Commentators that say the United States has a stronger economy are basically saying, “the Americans are driving faster”, but the question is whether this difference is sustainable in the long run.
The United States is running trillion-dollar deficits (5% of GDP in 2019 during an economic high point) that are accelerating with no end in sight. We have more fiscal stimulus and less monetary stimulus than some of our peers while also having a structural current account deficit. The U.S. dollar is historically expensive relative to other major currencies, which in part is what allows Europe to have a record trade surplus with us.
This all goes back to say that I’m not exactly bullish on U.S. stock performance over the next decade compared to some alternatives. And I’m saying that as someone who has invested heavily in U.S. equities for the past decade, since I bought heavily starting in April 2009 and haven’t stopped.
After the longest economic expansion in U.S. history, record corporate profit margins, a strong dollar, corporate tax cuts, record corporate leveraging to buy back shares, and the second highest equity valuations in history after the 2000 dotcom bubble, I think there’s more downside risk than upside potential from this level. The layers of the onion have been very good to us over the past decade, and it’ll be harder and harder to squeeze more outperformance out of the market compared to our international peers.
That doesn’t mean we can’t get further upward numbers on the S&P 500 before the cycle turns. If the Federal Reserve becomes more accommodating, if we dodge a full recession and resume growth, and if trade disputes are at least partially resolved, we could get another move up in the U.S. market towards a euphoric top. On the other hand, if some negative catalysts occur or none of those positive outcomes materialize, we could be headed towards recession and a selloff in the stock market.
My largest position remains in U.S. equities, but I believe it’s important to be diversified into multiple asset classes and regions going forward, and my portfolios reflect this. I’m selective with the type of U.S. companies I buy, and am rather defensively positioned for my age with some allocations to short-term Treasuries and gold because I expect better stock-buying opportunities ahead.
Until mid-2018, I had three investment accounts. One of them was a standard index-fund retirement account, one was an IRA filled with individual stocks and ETFs, and one was a taxable account, also filled with individual stocks and ETFs. My indexed retirement account is naturally fairly diverse, while my other portfolios tend to be quite concentrated and focus on investments that my retirement account can't invest in. As such, each portfolio only makes sense in the context of the whole.
So, I started a fourth account on September 12th, 2018 with $10,000 of new capital for the sole purpose of being a self-sufficient model portfolio that I can track dollar-for-dollar with my readers. I put an additional $1,000 into every six weeks, totaling $18,000 in contributions so far (including the original $10,000).
It’s by far my smallest account, but the goal is for the portfolio to be accessible and to show readers my best representation of where I think value is in the market from a long-term perspective.
After adding the eighth round of $1,000 in fresh capital in August, here’s the portfolio today:
Here is the full list of holdings within those various sections:
And here is what the 1-year performance looks like, thanks to the power of dollar-cost averaging:
I have two potential benchmarks to monitor the portfolio’s performance. The first one is simply the S&P 500 with dividends reinvested. The second one is the Thrift Savings Plan 2050 Lifecycle Fund. I write weekly articles about the Thrift Savings Plan for federal civilian and military personnel (one of the largest retirement systems in the world), and they use low-cost diversified index funds with a good database for dividend-inclusive historical returns. The Lifecycle 2050 fund consists of U.S. stocks (large and small), foreign stocks, and bonds suitable for someone roughly my age.
Here is the result, showing the investment gains that my portfolio generated over the past year compared to if I had put identical sums of money into the S&P 500 or TSP 2050 Lifecycle Fund at the same time:
As of today, the portfolio has $19,681.59 in value plus $39.84 in non-reinvested cash totaling $19,721.43. So, the investment gains from my $18k contributions were $1,721.43. And it was a rather low turnover portfolio; I’ve only sold a handful of positions over the past year, and about 90% of it has been an unchanging core.
If I had put the same contributions into the S&P 500 at the same dates, I would have only $19,137.51, or $1,137.51 in gains. Putting the same money into the L2050 fund would have resulted in only $18,713.31, or $713.31 in gains.
Overall, my model portfolio had the highest returns and significantly less volatility than both, and in particular a much shallower decline in December 2018 during that big market selloff. It certainly won't outperform like this every year, but it's a nice start, and hopefully it is helpful to readers for providing some investment ideas.
Next, I'll briefly discuss the sections of the portfolio to cover why its various components outperformed or underperformed during this period.
Dividend Stocks (25% of Portfolio)
The dividend stock section of the portfolio is one of the biggest pieces, at 25% of the portfolio, and was responsible for the biggest dollar-amount increase during the year. It consists of individually-selected dividend stocks. The money-weighted return was 24.79% while the S&P 500 has been relatively flat over the past year, thanks to dollar-cost averaging and good stock selection.
I wrote an article in October of last year called "7 Top Stocks to Buy and Hold for the Next Decade", and I included all seven of those stocks, and others, in this section of the model portfolio.
As luck would have it, all 7 of the stock picks have outperformed the S&P 500 since I wrote that article (5 of them by a lot, 2 of them just by a few points), and collectively they had an average return of 30.06% compared to 9.65% for the S&P 500 (SPY) including reinvested dividends:
I've freshened the data on that article a few times over the year like P/E ratios and dividend yields as readers keep pouring in, but haven't changed any of the stock picks. Likely around the new year I will remove one or two of them and replace them with another pick with more upside potential. Keeping with the name of the article, those removals won't be considered "sells" but will instead just be "holds".
There have been a couple laggards for the year in my dividend stock portfolio, but dollar-cost averaging and good stock selection overall have minimized their impacts. For example, my money-weighted return on Apple (NASDAQ:AAPL) is 15.44% even though the stock is lower than when I started the portfolio. I've been dollar-cost averaging into it, which means many of my shares have been accumulated at those lower levels for the period:
International Equity (25% of Portfolio)
The international equity section of my portfolio consists of international ETFs for geographic diversification outside of the United States, and currently consists of 25% of the portfolio.
With relatively flat returns of 2.30% after dollar-cost averaging for the year, this section has been a mild drag on overall portfolio returns, because investing almost anywhere outside of the United States within the past year has basically been like shoveling money into a bonfire.
As I described earlier in my section on paradigm shifts, though, I don't expect this divergence to continue forever. The U.S. dollar is strong for a variety of reasons despite big twin deficits that historically are bad for currency strength. Many other country stock markets and currencies are at much lower valuations, and I especially like certain (not all) emerging markets for the next 5-10 years, particularly the ones without huge piles of external debt.
There are many reasons for the U.S. dollar to be strong right now, and for U.S. equity valuations to be high, but from this elevated level it would be easier for foreign stocks to outperform U.S. stocks next decade than the other way around. In the shorter term, some analysts expect the dollar to spike higher in the coming months, and that would put further pressure on emerging markets if it materializes. I don't have a particular opinion on that time frame and instead focus further out.
Cash/Bonds (20% of Portfolio)
My portfolio has a 20% allocation to short-term bonds and cash-equivalents as a defensive placeholder. If better buying opportunities open up, I would be happy to reduce or eliminate this allocation to buy more equities.
In hindsight, I could have made higher returns if some of these bonds were longer duration, but I didn't have conviction about the direction of long-term rates and kept it safe instead. I preferred the cash/gold barbell approach which worked quite well.
Commodities (10% of Portfolio)
Starting in October 2018, I added a small allocation in the portfolio to commodity producers, and then boosted that up to 10% due to high conviction. Most of this section is in precious metals producers rather than industrial commodity producers like oil or copper, and this section has been by far the best performer in the portfolio on a percentage basis with a 43.47% money-weighted return. It touched over 50% before we had the recent pullback in precious metals.
Slowing global growth and low or negative real interest rates are a good environment for precious metals to start doing well after a 6-year consolidation. I considered them to be reasonably valued and good defensive assets a year ago, and still do at the current time although we could easily see further pullbacks at this point. I explained my framework for investing in precious metals in a February article here on Seeking Alpha.
Growth Stocks (5% of Portfolio)
In early January, I added a small 5% allocation to growth stocks. The fourth quarter of 2018 saw a huge drop in major tech stocks, so I used the opportunity to load up on some shares of Alphabet (GOOGL), Adobe (ADBE), Visa (V), and similar companies, and this section produced good returns (28.05% money-weighted) from that point. I'd be happy to boost this to 10% of the portfolio if we get another good buying opportunity, but as they currently stand, I think a significant subset of growth/tech stocks are overvalued.
Real Estate Investment Trusts (5% of Portfolio)
I've had a 5% allocation to REITs since the portfolio was constructed, and as investors have shifted into higher-yielding assets with less global exposure, the sector has performed rather well. This section, which simply consists of the Vanguard REIT ETF (VNQ), had an 20.82% money-weighted return.
We'll see what happens in the coming months. The portfolio will likely underperform, at last for a time, if we get a blow off top in equities or another re-acceleration in economic growth. In contrast, the portfolio will likely outperform if markets take a turn for the worse or stay choppy and flat for a while.
Either way, I'll be dollar-cost averaging into it, and tilting it towards areas of value that I find.
I would advise readers to keep an eye on the rate of change of consumer spending, payrolls, and other key indicators in the coming months to see if growth continues to slow or if the economy re-accelerates. We can't time recessions precisely, but there's no reason to be caught off guard, one way or the other, about the general direction of the economy.
Disclosure: I am/we are long AAPL, V, GOOGL, VNQ, ADBE. 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.
Additional disclosure: I am long all stocks and ETFs shown in the portfolio.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.