How to predict a recession?
Hello there fellow investors who wish to predict a recession! Don’t worry, I am here to come to your rescue!
Recessions are a horrible time for anyone and not something we want to come along very often but unfortunately (whether we like it or not) they are inevitable.
What is a recession?
A recession is a macroeconomic term that refers to a significant decline in general economic activity. Typically it is recognised as a period where there are two consecutive quarters of economic decline, as reflected by GDP in combination with monthly indicators such as an increase in unemployment.
For example, since 1854, there have been 34 recessions in the United States with the most recent being 2020. These recessions are preceded by stock market crashes - for example bear markets where the S&P500 has fallen by an average of 20%.
Some of the largest stock market drops are January 1973 (48%), March 2000 (49%) and October 2007 (57%).
Can they be predicted?
For the most part, people will tell you that no they cannot. Which I think they are correct to a certain extent. However, there are some leading indicators that can give you a bit of a “heads up” to try and foresee the blood bath that may be ahead.
One of the most common recession prediction indicators that astute investors use is the yield curve. You can find a more detailed description of the yield curve here but essentially you have three main types of yield curve which relate to the shape of the curve:
Normal - you get a higher interest rate for lending your money to the government for a longer term when compared to a shorter term
Flat - you get the same interest rate for lending your money to the government for a longer term when compared to a shorter term
Inverted - you get a lower interest rate for lending your money to the government for a longer term when compared to a shorter term
If you have a normal yield curve, then the market expects a healthy economy. If the yield curve is flattening and becoming flat, then the market is expecting slower economic growth. If the yield curve inverts, then the market is expecting a recession.
The yield curve that has been proven to be most effective as a leading indicator for predicting recessions is the 10 year treasury yield minus the 2 year treasury yield. The FRED Economic Data website updates this regularly and you can see a plot of this here.
As you can see below, this yield curve has been a leading indicator for recessions and has historically inverted approximately 6months to 2years prior to a recession.
10-Year Treasury Constant Maturity Minus 2-Year Constant Maturity
Recently (April 2022 and July 2022), the yield curve has inverted again. However, this comes at a time when the stock market (S&P500) is already down by ~17% and other stocks being down significantly more.
10-Year Treasury Constant Maturity Minus 2-Year Constant Maturity (zoomed to 1 year)
SPDR S&P 500 ETF Trust (S&P500 tracker fund) Performance
So should we expect further declines or have we seen the worst of it?
Well unfortunately, the Federal Reserve (and other Central Banks) are currently undergoing a tightening phase where they are increasing interest rates and withdrawing liquidity from the system. Recession induced stock market crashes have tended to bottom when Central Banks change direction and start to support the economy (i.e. lowering interest rates and increasing liquidity). I think until inflation is reduced, we may not see Central Banks change direction in the short term.
Note: when I refer to liquidity I am essentially referring to how much money is being printed/ introduced into the system
Again, you can keep track of the Federal Reserve interest rate (Federal Funds Effective Rate) here and the Federal Reserve balance sheet here.
How do you know when a stock market crash has bottomed?
There is no way of knowing when the stock market has bottomed but, if the Central Banks have changed direction and started easing monetary policy (i.e. lowering interest rates and increasing liquidity) to support the economy, this is likely to give investors more confidence going forward. Therefore, you may expect that stock markets start to do better in advance or following these types of announcements.
Otherwise, you can also keep track of the CBOE Volatility Index which has been termed the “fear gauge”. This can be tracked here and measures market expectation of near term volatility conveyed by stock index option prices.
You can get a feel for where we are in terms of investor risk appetite and how it compares with previous major stock market crashes. At current levels, we have not yet reached the levels that were reached during the 2008 and 2020 crashes for example. However, there could be an argument that we are not yet in the major recession crash yet and that this could happen later in 2022 or 2023.
CBOE Volatility Index (VIX)
So what should you invest in during these uncertain times?
Well this all depends on where you are in your investing journey and what your risk appetite is. There is an argument that if you have a long term investment horizon and you are relatively early on your investment journey, that stock market crashes should not phase you and that you should hold almost 100% stocks.
However, that could mean a lost decade of returns for money invested during the peak of the market (e.g. 2000 to 2013 example).
SPDR S&P 500 ETF Trust (S&P500 ETF) Performance Showing 2000 to 2013
For me, my intention is to alter my asset allocations slightly during periods of macroeconomic uncertainty (such as the current period).
Government bonds (particularly long term government bonds) have historically been a good investment (and uncorrelated hedge to stocks) during recession induced stock market crashes.
Long term government bonds (20 year plus) have been in one of their worst ever drawdowns recently and look as if they have started to rebound. I have been adding to US and UK government bonds to hedge my portfolio in the event of further stock market declines and macroeconomic uncertainty.
