Are You Ready For The Next Recession?

The one thing that ALL investors agree on is that another recession is coming…someday.

In my experience, I have ran into clients and read articles that predicted recessions every year since the market recovered in 2009.

In 2010 it was Greece, in 2011 it was the European contagion, in 2012 it was the Fiscal Cliff (or Armageddon), in 2013 it was the Government Shutdown, in 2014 it was the Oil Crash, in 2015 in was Energy & China, in 2016 Brexit & the US elections, in 2017 it was the valuations as CAPE crossed 30, in 2018 it was the Interest Rate hikes, and in 2019 it’s the Trade War and Yield Inversion.

The point of listing the major scares above is simple - although we can all agree that a recession is coming, we have no idea when it will happen. It could start next year or 5 years from now or it could have started last week. It can be short or very long, sharp or gradual, expected or totally unexpected.

So, how do you prepare for something you know will occur but have no idea when?

This is “The Question” that all asset owners and asset managers need to answer for themselves.

Here are the approaches I have seen investors do to respond to recession fears:

  1. Buy and hold diversification (bonds and alternatives)

  2. Buy and hold quality value stocks.

  3. Tactically de-risk the portfolios based on qualitative / economic analysis.

  4. Let allocations drift as markets drop i/e underweight equities vs strategic targets.

  5. Factor balance portfolio like Risk Parity or Norway.

  6. Buy structured products.

  7. Tail hedge the portfolio with options or other solutions.

  8. Invest in private equity obfuscating volatility & restricting ability to market time.

  9. Rotate portfolio into ‘safer’ assets like low volatility, higher quality stocks & sectors.

  10. Dynamically change asset allocations based on a model, typically based on trend + volatility forecasting.

  11. Panic and go to Cash.  

…did I miss any?

Based on my observations, investor responses to recessions fall into three groups:

Type 1: Have an explicitly articulated formalized investment philosophy with a disciplined process and implementation.

  • Recession may or may not affect allocations, but whatever the approach, it gets adhered to throughout the full cycle.

  • Some of these approaches (like over-diversification, or over-paying for protection) may not deliver satisfactory long-run results. But because they get adhered to consistently, you can evaluate them and chose the ones that align with your investment philosophy.

Type 2: Subjective, gut-driven reactions, big bets, de-risk, re-risk, go to cash, get back in, lever up to catch up, chase yield, go with the news, follow the herd, override the model, make unpredictable portfolio changes.

  • Sometimes, we hear about people who can do this extremely well and make some big right calls. We typically don’t hear about the other side.

  • Although this type does not sound ‘prudent’, it’s not that dangerous if the asset owner is clear upfront that this is the way they will manage the portfolio in response to recessions. One can assess the risks of such approaches, measure their effectiveness, and add constraints & safeguards.

Type 3: On paper, these investors look like Type 1, but in practice, act like Type 2.

  • This is the most ‘dangerous type’, because it’s not possible to risk-manage such investors. As a quant, I can roughly estimate the risks of most type 1 and type 2 approaches; however, type 3 is non quantifiable. It’s the unknown unknown.

  • Imagine if Vanguard’s static 60/40 balanced portfolio, clearly a type 1 approach, suddenly changed to a 10/90 for a couple months during the next recession. While this sounds like an extreme violation of the investment policy statement, I believe a milder version of this ends up being the most frequent path for most portfolios.

[As a side note, during the past few years Vanguard did something similar, yet less dramatic and in the opposite direction by changing the ‘default balanced’ from 60/40 to 70/30 in order to ‘meet investors expected returns’]

  • Unfortunately, most people want to think of themselves as Type 1, but end up acting as Type 2, which makes them Type 3 investors. The aggregate impact of this approach is captured by the “Gap” - which is why I call it the ‘largest cost to investing’.

Investors don’t become Type 3 on purpose. They try to select Type 1 approaches, but typically miss the required depth of alignment and belief that is required to stick with a chosen approach. Picking an ‘off-the-shelf pie-chart solution’ from a branded firm or trying to invest like Mr. Buffett or Mr. Dalio by reading a book about their work typically does not generate enough strength of belief to sustain commitment to such approaches during difficult times.

So, Are You Ready for The Next Recession?

  • If you have clearly articulated how you are going to make decisions before, during and after the next recession; and you will stay with the approaches you believe will result in the best expected outcomes, then the answer is Yes.

  • If you have doubts - then you are probably trying hard to be a Type 1, while a part of you knows that you (or your team) have a big dose of Type 2.

    • In this case, rather than trying to force everything into a Type 1 approach, review your portfolio and decide explicitly ahead of time what kind of ‘Type 2’ decisions you will make ‘without a plan’ and by how much you will allow them to affect your overall portfolio.

    • Then spend time designing your own ‘Type 1’ investment philosophy that aligns with your beliefs about the markets and your own behavior.