Preparing for the Recession - YouTube

- It has been more than a decade

since the last U.S. recession.

And prior to that,

the longest gap between recessions was exactly a decade.

As I record this video the U.S. yield curve is inverted

and an inverted yield curve

meaning that the rates on longer-term bonds

are lower than the rates on shorter term bonds,

is well-documented as a good predictor

of a coming recession.

On average, stock returns during U.S. recessions

have been negative

for a globally diversified Canadian investor.

Nobody wants to lose money.

So it's common to wonder what can be done

to avoid the potentially negative stock returns

that often come with a recession.

I'm Ben Felix, portfolio manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you how to prepare for the next recession.

If we look back the last six U.S. recessions,

we can see that a Canadian investor

investing in a portfolio of Canadian, U.S.

and international index funds

would have lost money in most but not all cases.

It makes perfect sense that investors get nervous

when recession signs start flashing.

Unfortunately, feeling nervous

does not make market timing and easier.

As much as we may want to avoid negative stock returns,

getting out of stocks before a recession

and back in when it's over is much easier said than done.

The yield curve is one of the most well-known signs

of a coming economic recession.

And in the U.S. it has had pretty good predictive power.

There've been eight U.S. yield curve inversions

and seven U.S. recessions since 1966.

And an inverted yield curve has successfully forecasted,

within six quarters, six of those recessions.

There was one false positive in 1966,

when an inversion was not followed by recession

within six quarters,

but there was still an economic slowdown.

As useful as it may be as an economic indicator,

the challenge with using the yield curve

to make investment decisions

is that even if the indicator is a perfect predictor

of a coming recession, it may not be a good predictor

of future stock returns.

Eugene Fama and Kenneth French addressed this

in a July 2019 paper,

titled Inverted Yield Curves and Expected Stock Returns.

Fama and French acknowledged

that there is strong empirical evidence,

some of it's stemming from Fama's own work,

suggesting that the slope of the yield curve

predict economic activity

and inverted yield curves

tend to forecast future recessions.

To relate this to stock returns,

Fama and French built a market timing model

that moves out of equities and into treasury bills

when the local yield curve is inverted.

They analyze three portfolios

from the perspective of a U.S. investor,

the U.S. market, the World EX-US market

and the World market.

The analysis was designed to test whether or not

an actively managed strategy

that shifts out of equities and into treasuries

based on yield curve inversions

adds value to portfolio returns.

This is the question that everyone wants to answer.

If the yield curve is an imperfect

but historically pretty good predictor

of a coming recession, can we use it to time the market

or at least make some portfolio changes

to protect our portfolios?

Based on their analysis, Fama and French conclude that,

"The results should disappoint investors

hoping to use inverted yield curves

to improve their expected portfolio return.

We find no evidence that yield curve inversions

can help investors avoid poor stock returns."

They go on to explain their interpretation of this finding.

The simplest interpretation

of the negative active premiums we observe

is that yield curves do not forecast the equity premium.

This interpretation implies

that investors who try to increase their expected return

by shifting from stock to bills after inversions

just sacrifice the reliably positive

unconditional expected equity premium.

Stated another way,

the yield curve should not inform your investment decisions

and attempting to make portfolio changes

into safer assets based on the expectation

of a coming recession,

as predicted by a yield curve inversion,

is more likely to do you harm than good.

This is for two main reasons.

We can not predict when a recession will happen.

And even if we could

we can not predict a stock returns

that are going to occur during a recession.

Moving into safer investments decreases your exposure

to the persistently positive expected returns of stocks.

This does not mean that we are powerless

to prepare our portfolios for recessions.

A properly diversified portfolio,

diversified across geographies,

asset classes and risk factors,

is probably the best way to prepare for any economic outcome

including a bad one.

In a 2017 paper,

titled Fama French Factors and Business Cycles,

authors Arnav Sheth and Tee Lim

looked at the performance of the market, size, value,

momentum, investment and profitability factors

across business cycles.

Remember, owning a market cap weighted index fund

gives you exposure to the market factor.

To gain exposure to the other factors

you would need to overweight those types of stocks

relative to the market.

For example, exposure to the value factor

would require adding additional exposure to value stocks,

stocks with low prices,

on top of a market cap weighted index fund.

Sheth and Lim broke the business cycle into four stages.

Recession, early stage recovery,

late stage recovery, and very late stage recovery.

And they examine how each of the factors performed.

They also looked at the performance

of the factors following yield curve inversions.

They looked at the 10 us recessions

designated by the national Bureau of Economic Research

going back to 1953.

They examined the cumulative factor returns

for the 10 months following each recession,

which is the median length of historical U.S. recessions.

They found that the best performing factors

in a recession on average were the investment factor,

with an average cumulative 10 month premium

of 18.3% during recessions,

followed by the value factor

with an average cumulative 10 month premium

of 12.5% during recessions.

In the early and late stages of the economic cycle,

the investment premium tapered off quickly

while the value premium remains strong

into the very late stage before tapering off.

Possibly the most interesting insight from the paper

is it the you premium has historically been lowest

in the very late stage of the economic cycle.

The reason that this is interesting

is that as that August, 2019,

U.S. value stocks have been underperforming

U.S. growth stocks in terms of annualized returns

for over a decade.

If we look back in time,

the decade ending on March 31st, 2000

looked very similar to today

with value stocks having trailed growth stocks

for more than a decade,

in terms of average annualized returns.

When the 2001 us recession hit,

the effect on growth stocks was dramatic enough

that for the decade ending March, 2001,

that is just moving ahead one year from March, 2000,

the whole trailing decade showed a positive value premium.

Despite nine years of overlap,

that one year made the difference.

This anecdote is in line with the research findings

from the Sheth and Lim paper.

The value premium tends to be weak

late in the economic cycle

and strong in recessions and early stage recovery.

What this does not mean

is that you can time the value factor.

Remember, the Sheth and Lim paper

is observing known recessionary periods

with perfect hindsight.

Even if we know that value tends to do well in recessions,

we still can not predict the exact timing of recessions.

What chef and limbs finding does mean

is that the known risk factors perform differently

at different stages of the economic cycle,

making diversifying across risk factors

an important part of managing a portfolio.

This should come as no surprise.

Factor diversification was identified

as a crucial aspect of diversification

in a 2012 paper by Jared Kizer and Antti Ilmanen,

titled the Death of Diversification

Has Been Greatly Exaggerated.

They found that factor diversification

has been more effective

than asset class diversification in general

and in particular during crisis.

I must reiterate though

that this should not be viewed as a market timing decision.

An allocation to value stocks is a long-term decision

and it is not always an easy decision to live with.

Value's poor performance over the past decade

has not been an easy pill to swallow for value investors.

As tempting as timing a trade into value may be,

a 2017 AQR paper built a value timing strategy to test this

and they found lackluster results.

They concluded that maintaining consistent factor exposure

is a tough benchmark to beat.

I have not told you anything new.

Market timing is hard and diversification is important.

It is general optimal to stay invested

in a risk appropriate portfolio all of the time.

Otherwise, as Fama and French point out,

you sacrifice the reliably positive

unconditional expected equity premium.

Based on how different risk factors performed

through the business cycles,

one of the best ways to be prepared for a recession

might be overweighting value stocks relative to the market

to gain exposure to the value factor.

Thanks for watching.

My name is Ben Felix of PWL Capital

and this is Common Sense Investing.

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who you think could benefit from the information.

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