- Bear markets are a healthy cleansing process that removes the excesses of the past.
- This is the second part of a series of articles on this subject.
- The objective is to educate investors on how to spot a "bear market,” what to do in such an eventuality, and possibly benefit from it.
- Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »
Co-produced with Trapping Value
Bear markets can be very devastating if they catch you off guard.
This is part 2 of a series of articles we are writing about this subject. In the first part of this series we explained why the possibilities of a bear market are growing and why the final top may be close. We went through three major indicators that suggest that the business cycle could be peaking and turning and the final top might arrive within 12 to 24 months. If you did not have a chance to read Part 1 of this series, this is the link:
In this part, we will focus on why the upcoming recession is likely to be mild. In later parts we will focus on:
- Why bear markets are necessary and what the average investor can do to prepare (Part 3 of this series).
- We also will calculate returns that the standard 60:40 strategy is likely to deliver at that point (Part 4).
- Finally, we will identify a few asset classes (Parts 5 and 6) that will beat the living daylights out of the indices.
A quick recap of part 1 and updates
The case for the bear market and possible recession was based on three major factors. A downturn in the leading economic indicators, a model-based forward-looking employment indicator and an inverted yield curve. While individually they are moderately strong signals, together they represent a powerhouse of forecasting strength. Since then, we have delved further into the situation and have noted a vast majority of indicators that suggest a very serious slowdown somewhere between the second and third quarters of this year.
One additional indicator we want to point to is in our opinion perhaps the best forward-looking measure between the "smart" and "not-so-smart" money. Here the "smart" money is represented by CEO expectations and the "not-so-smart" money by consumer confidence. The indicator is calculated as a spread (CEO expectations minus consumer confidence) and this spread has hit an all-time low.
Why does this indicator work?
Well, the CEO confidence is what dictates capex and job creation. They also have a real time pulse on inventory levels and contract signings. They are hence a fantastic forward-looking indicator. Consumer confidence on the other hand is somewhere between a lagging and a coincidental indicator. Therefore, a spread between these two is a measure of how bad the future is vs. the present. When this widens significantly, a turn is close. As can be seen on the chart above, the economy has moved into recession at far lower spreads than where we are at today. This is a very strong danger signal and suggests when the turn comes, adjustment to reality would likely be quick and painful.
The depth of the next recession
One of the key reasons markets were so unprepared for the 2008-2009 recession was that the one prior to that was probably the mildest recession the US ever suffered. GDP contraction in the 2001 recession was so mild that it was hardly a blip. Investors with recency bias extrapolated that recession as the most likely possibility and what we suffered was far more extreme. But as we stand today, there are compelling reasons as to why the next US recession will be significantly milder. We go through these below.
Household balance sheet continues to look strong
Not only have households refused to buy into this expansion, they also have completely eschewed leverage. Household debt service ratio is still moving lower and is the lowest in 40 years.
Source: JP Morgan
Yes, this is dictated by low interest rates and certainly rising rates could stress this ratio. However, a very large percentage of this debt is made of mortgages and a very large percentage of mortgages are long-term fixed rate mortgages.
Another way to examine this is to look at the household debt to GDP and this ratio has also been cruising lower with no suggestion of consumers wanting to take on additional leverage.
Finally, the personal savings rate continues to be rather strong and it dovetails the same cautious consumer that we have come to see in the charts above.
All of these suggest that the consumer will hold up better than in the past recessions should the economy weaken and that will mean that the domino effects we saw in the last recession will likely not transpire.
Pent-up demand for homes
While the last recession was characterized by wild speculation into the overheated housing market, residential investment as a percentage of GDP has stayed rather low.
Source: JP Morgan
We are currently below the 6 decade long average and this indicator has little room to fall in a recession. New home sales as a percentage of the civilian population is still near the bottom 5 percentile if you look at the time frame between 1960 and 2001.
All of this is indicative of significant pent-up demand for housing which has to still to be tapped ahead.
Pent-up demand for autos
The consumer savings rate also has made for a weak and tepid recovery in autos in this expansion. Motor vehicles and parts consumption as a percentage of GDP is about 20% lower than normal and has been stuck in first gear since the recession.
The US car fleet has continued to age as a result and is now bordering on 12 years. This is again an area of potential expansion out of sheer necessity. Part of this hold-back is because the ghosts of 2008-2009 are still fresh as daisies. As consumers see that the next recession is far milder, we think this indicator will move up from its depths.
Which is more important, household or corporate leverage?
While we are bring up the household side of the equation there has certainly been alarm raised about the corporate side. Most notable point here is the stretched corporate balance sheet. That is represented by how much of investment grade bonds (LQD) (SLQD) sit just one rung above junk (HYG) (JNK).
Our take here is that this is more likely to be a concern for the stock markets rather than the economy. While the two move hand in hand to an extent, when we do hit a recession, we will see some divergence with the stock market (SPY) (DIA) (QQQ). Corporate balance sheet repair is likely to leave less cash left for buybacks and dividends but the economy is likely to be powered ahead by the stronger consumer. While that may sound like an incredibly hard to believe statement, do note that we have had several decade-long periods where markets have been net flat while the GDP has gone up significantly. During March 2000-September 2013 for example the S&P 500 was about flat while cumulative nominal GDP was up over 60%.
So we are making a case that the economy and not necessarily the stock market will do well from these levels.
While we remain cognizant of the stretched conditions of the stock market outside a few sectors, we do not see the US consumer as "stretched." Certainly, if the economy rolls over, the consumer will pull back. Rising unemployment will add to that as well. But the consumer is nowhere near tapped out and their balance sheets have been significantly repaired. This to us means that the next recession will be shallower than average and far better than the last. The stock market though may still have more headwinds as US stock multiples are in a very distinct and different department.
Unfortunately today many investors have never seen a bear market. One of the most value-added features of our service is providing frequent macro-economic and technical analysis in order to stay ahead of the game (i.e. being fully invested during bull markets, and take defensive positions during "bear markets").
When a recession is looming, there's need for proactive actions to ensure your income is steady and safe. The good news is that bear markets also can provide a great opportunity to see both income and portfolio grows rapidly.
In the next part of this series, we will examine how the average investor should prepare for a bear market.
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This article was written by
Rida Morwa is a former investment and commercial Banker, with over 35 years of experience. He has been advising individual and institutional clients on high-yield investment strategies since 1991.Rida Morwa leads the investing group Learn More.
Analyst’s 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.
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