Avoiding Recessions: Why Does it Matter?
In a recent Federal Reserve research paper, it was noted that the 2008 Financial Crisis wiped out all the wealth gained for 50% of the US population over the previous four decades. That’s 40 years of savings, investment gains, and increased financial security for more than 100 million Americans that evaporated in just a few short years. The impact of the 2008 Financial Crisis was nothing short of devastating. At Prepared Capital, our goal is to provide investors a means to invest for their future while providing a level of protection from recessions.
To accomplish this lofty goal, we developed our Business Cycle Indicator. It is an algorithm that uses a combination of economic and financial market data to predict recessions. Through back-testing, our indicator would have successfully predicted each of the last seven recessions, including the 2008 Financial Crisis. Using this research we created our CycleWise Portfolios that invest in US stocks and bonds, but the allocation between the two asset classes changes prior to a recession.
How does it work?
Since 1968, the US has experienced seven recessions. The table below shows the month that each recession started, and the month which our Business Cycle Indicator warned of a recession. Notice that in each instance, our indicator provided a warning in advance of the recession. On average, 13 months in advance.
Prior to every recession, there are tell-tale signs that trouble is brewing inside the economy. These signs are often dismissed at the time because investors think “This time is different”. By the way, those are the four most taboo words in investing. Our Business Cycle Indicator tracks those tell-tale signs and provides a warning when the risk of a recession begin to rise. Importantly, there is zero subjectivity to the process. It leaves nothing to human interpretation, it simply tracks the data.
The average stock market decline during a recession was 32%. The last two recessions, 2001 and 2008, dealt investors above average losses of 46% and 52%, respectively. As anyone who was investing during those periods knows, they were difficult times. Our Business Cycle Indicator is designed to provide a warning of such events. To be clear, our indicator is not trying to “time” the stock market. In fact, the last change in our Business Cycle Indicator was July 2009. What it is timing is changes in the Business Cycle.
Our CycleWise Portfolios are designed to change their composition depending on where the US economy is in the business cycle. The portfolios favor a blend of stocks and bonds when our Business Cycle Indicator points to economic growth, and bonds when it warns of a recession. When a recession occurs, interest rates tend to fall. There are two main reason why this happens. First, the Federal Reserve lowers interest rates during a recession to stimulate the economy. Second, during a recession investors allocate more of their capital to bonds because they are safer than other investments.
Below is a table that shows the performance of two prominent US bond indices during the last two periods our Business Cycle Indicator warned of a recession. The Barclay US Aggregate Bond Index is designed to track the entire bond market in the United States. It is comprised of thousands of bonds including mortgages, investment grade corporate bonds, high yield corporate bonds, and government bonds. The US Treasury Index is made up of all the US government bonds with a maturity of at least one year.
As each of the last two recessions unfolded, more and more investors opted for the safety of bonds. That increased demand for bonds drove prices higher and produced the gains noted in the table above. Our CycleWise Portfolios are designed to capture this change in investor preference by investing in bonds when our Business Cycle Indicator warns of a recession.
CycleWise Performance During Recessions
The chart below illustrates our Aggressive CycleWise Portfolio, which consists of 85% stocks and 15% bonds, would have performed during the last two recessions. Like all of our CycleWise Portfolios, when our Business Cycle Indicator warns of a recession, the allocation changes to 50% US Aggregate Bond Index and 50% US Treasury Bond Index. We compare our aggressive portfolio vs a buy-and-hold portfolio consisting of 85% stocks and 15% bonds.
2001 Recession: Bursting of the DotCom Bubble
We examined the performance during the period that our Business Cycle Indicator warned of the 2001 recession. The initial warning came in August of 2000 and remained until December of 2002. During this period, our CycleWise Portfolio outperformed a simple buy and hold portfolio by a staggering 55.5%. The outperformance is achieved simply by being invested in bond during a recession.
2008 Recession: The Global Financial Crisis
We also examined the period when our Business Cycle Indicator was warning of the 2008 recession. The initial warning came in September of 2006 and remained until July 2009. During this period, our CycleWise Portfolio outperformed the buy and hold strategy by 37.5%. Again, demonstrating how much better bonds perform during recessions.
Our portfolios page highlights how each of our five models performed between 1995 and 2017. We are now 9 years into what is now the second longest business cycle in US history. It is only a matter of time before the next recession occurs. We simply provide a way for investors to mitigate the impact.