Fears of an imminent recession are getting kind of old at this writing; any investors who retreated some or all their portfolios to the sidelines in anticipation that the economy was about to tank are now ruing their luck, as the markets delivered another quarter of solid returns. It’s another version of the lesson: listen to the pundits predicting disaster at your (financial) peril.
What if somebody could tell you the exact date when the next recession will begin, so you could get out of the market and wait it out. Wouldn’t that be great?
You can fantasize about this if you want. But it so happens that sitting on the sidelines during an economic recession is bad for your portfolio returns.
A study conducted by a mutual fund company called Dimensional Fund Advisors did something very simple: it looked at the start date of all recessions from January 1947 to December 2022, as announced by the National Bureau of Economic Research. Then it calculated the returns of the Standard & Poors 500 index for the ensuing one year, three and five years after the recessions were formally declared. Finally, it averaged those returns to show how investor portfolios, on average, fared during those times when the economy was in the tank.
The result was not encouraging to those who plan to move to the sidelines during recessions. On average, one-year market returns after the start of a recession came to a decently positive 6.4%. Three-year returns and 5-year returns were even more so: 43.7% and 70.5% over those time periods.
Looking over the data, the researchers noticed that markets have, on average, tended to experience most of their bear market declines before recessions were announced, and began recovering soon afterwards. The markets tended to trend upwards during the recession, perhaps because investors anticipated that it would end soon and good times would restore corporate health.
The bottom line is clear: even if you knew the exact date and time that a recession would be announced (and you don’t),
the future market movements would still be uncertain—and, on average, counterintuitive. Better to throw dice, or
darts, or examine turtle shells to find out what’s coming in the future.
The market gains in the second three months of 2023 were stronger for larger stocks, but all sectors participated in the
sunny investment climate. The Wilshire 5000 Total Market Index—the broadest measure of U.S. stocks—picked up
6.67% gains in the second quarter and is now up 16.30% in the first six months of the year. The comparable Russell 3000
index is up 16.17% so far this year.
Looking at large cap stocks, the Wilshire U.S. 2500 Large Cap index gained 6.67% in the most recent quarter and is up
16.53% through the first half of the year. The Russell 1000 large-cap index has gained 16.58% so far this year, while the
widely quoted S&P 500 index of large company stocks jumped 8.30% in the second quarter, and has now gained 15.91%
during the year’s first half.
Meanwhile, the Russell Midcap Index is up 9.01% through the second quarter. The Wilshire Midcap index gained 4.55%
in the recent quarter, to stand at a positive 8.30% so far this year.
As measured by the Wilshire U.S. Small-Cap index, investors in smaller companies received a 5.58% gain for the most
recent quarter and are now sitting on 9.83% gains. The comparable Russell 2000 Small-Cap Index posted a 8.09% return
over the past six months. The technology-heavy Nasdaq Composite Index, the biggest loser in 2022, is on a tear this
year, posting a 31.73% return in this year’s first six months.
Foreign markets are delivering positive returns as well. The broad-based EAFE index of companies in developed foreign
economies gained 9.66% in the first half of 2023. In aggregate, European stocks are up 8.95% this year, while EAFE’s Far
East Index delivered a positive 2.58% performance. Emerging market stocks of less developed countries, as represented
by the EAFE EM index, gained 3.46% in dollar terms over the last six months.
Despite rising concerns about the impact of remote work and e-commerce on commercial properties, real estate
securities produced decent returns. The Wilshire U.S. REIT index posted a 6.66% gain in the first quarter of 2023.
However, other alternative parts of a diversified portfolio were not so fortunate. The S&P GSCI index, which measures
commodities returns, lost 11.41% of its value in the most recent six months. Utility stocks are posting a rare 7.16% loss
so far this year.
Bond rates rose dramatically last year, but that trend seems to have moderated. 30-year U.S. government bond yields
barely moved from where they were three months ago, with current yields at 3.86%. 10-year government bonds are
yielding 3.84%, and from there we enter the inverted yield curve: 5-year government securities are yielding a higher
4.16%, 2-year Treasuries are yielding 4.90%, one-year government bonds are yielding 5.39% and 6-month securities are
now yielding 5.41%. To say this is not normal is an understatement. Whenever shorter-term bonds are paying bond
investors more than their longer-term counterparts, it means that bond investors (and, maybe, most professional
investors) are feeling cautious about the future of the market.
Municipal bonds are a somewhat less dramatic story now, but there is still inversion going on; 30-year municipal bonds,
on average, are yielding 3.57%, and 10-year maturities are yielding 2.55%. But the inversion can be seen in 5-year
(2.61%), 2-year (2.92%) and 1-year (3.01%) aggregate yields.
Of course, we’re all wondering: will the second half of the year be as rewarding as the first half was? Our economic
future has seldom been as cloudy as it is today, which is to say that the indicators are all over the place. In America’s
manufacturing sector, the ISM Purchasing Managers Index, a closely watched indicator of the health of manufacturing
firms overall, suggests that manufacturing has been in a recession for the past seven months. Global indicators are
saying essentially the same thing about manufacturing competitors overseas. New export orders for goods have been
falling globally at the fastest pace since the end of 2022.
Adding to the downbeat news, the Conference Board’s Leading Economic Index has been declining for 13 consecutive
months, and the most often-cited recession indicator, the dramatic yield curve inversion in the bond market, is flashing
its signals louder than ever. The corporate sector has not been unaffected by all this: financial and non-financial U.S.
corporations have reported lower profits for the past two quarters.
But those indicators might make up less than half the story. The unemployment rate in the U.S. remains under 4%
(bouncing between 3.4% and 3.7%) and the labor participation rate among workers aged 25 to 54 stands at a very strong
83.4%—the highest level since 2007. Consumer spending has remained brisk, with durable goods orders up 1.7% last
month over the previous month. U.S. households are still flush with cash that was saved during the pandemic; the
Federal Reserve Bank of San Francisco has estimated that households still have sufficient savings to support current
spending levels at least through the fourth quarter of 2023. Indeed, the most recent consumer confidence index,
measured by the Conference Board, rose to 109.7, the highest since early 2022.
And, not incidentally, the inflation rate keeps falling. Last year, alarm bells were sounding because June’s annualized
rate hit 9.1%. Today’s rate is an annualized 4.0%.
There’s no reason to imagine that any of us can predict the future with any accuracy, except to point out that markets
have, historically, trended upward and rewarded patient investors. It’s possible that a future recession will test our
collective patience once again, but it’s a test that will be easier to pass due to the gains that this year has provided us
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