Should You Sell Out of Your Stocks in the Next Recession?

I was reading an article a few weeks ago, and the author used a 10-year chart to illustrate a point. It was one of those charts where vertical gray bands are used to denote recessions.

What caught my eye was that the last U.S. recession, 2007-2009, was disappearing off the left edge of the chart. And it dawned on me that a lot of Daily Trade Alert readers have never invested during a recession. If you’re 45 and started investing when you were 35, you have never invested during a recession. If you’re 55 and started thinking about investing at 45, neither have you.

Here’s a 12-year chart to show the last recession – the Great Recession – fully. It’s the gray band near the left.

The Great Recession no longer appears on a 10-year chart. Memory of the recession is fading, and many of you have no experience investing during one.

What’s a Recession?

Recessions are not officially declared by a government agency or the Fed. The National Bureau of Economic Research (NBER) is universally recognized as the go-to source for dating recessions. The gray bars on stock charts are based on the NBER’s dating of recessions.

The NBER’s Business Cycle Dating Committee (BCDC) maintains records of U.S. business activities. Their timeline tracks alternating peaks and troughs in economic activity, because a recession is the period between a peak and a trough. An expansion is the period between a trough and a peak. [Source]

During a recession, a significant decline in economic activity spreads across the economy.

A recession can last from a few months to more than a year.

Conversely, during an expansion, economic activity rises substantially, spreads across the economy, and usually lasts for several years.

To determine when the economy is contracting, which means we’re in recession, the BCDC examines the behavior of various measures of economic activity.

Because of its reliance on measured data, the NBER’s determinations of economic turning points come after the turning points have actually happened.

For example, the Great Recession is dated December 2007 – June 2009.

The BCDC’s declaration of the economic peak in December 2007 came 11 months later, and its determination of the trough in June 2009, that ended the recession, occurred 15 months later.

The NBER states that the BCDC waits long enough so that the existence of a peak or trough is not in doubt and the Committee can assign a month to it. (They don’t try to pinpoint the exact day within the month.)

Those who were investing in early-to-mid 2009 may recall the vigorous debates between the “pessimists” that saw the lingering weak economy as meaning we were still in recession, and the “optimists” who saw “green shoots” and other indications of economic expansion.

That was more than an academic disagreement, because real people were making real-time investing decisions based on which side of the fence they were on. The pessimists were advising to get out or stay out of the stock market –often ridiculing stock investing – while the optimists were seeing the low stock prices as rare investment opportunities in great companies.

The issue exemplified by that debate comes down to this: A weak economy can be expanding, and a strong economy can be contracting. It is the direction of change, not the level, that determines whether we are in a recession. NBER puts it this way:

[A] recession–the way we use the word–is a period of diminishing activity rather than diminished activity. We identify a month when the economy reached a peak of activity and a later month when the economy reached a trough. The time in between is a recession, a period when economic activity is contracting.

How Many Recessions Have There Been?

There have been 15 recessions since 1926.

 [Image source]

Do Recessions Match Bear Markets?

Recessions and bear markets are not always simultaneous, although they often overlap.

There have been 21 bear markets (defined as a 20% decline in the S&P 500) since 1929. Only 11 of them have coincided with recessions, which means there have been 10 independent bear markets not associated with recessions.

Obviously, things besides general economic contraction can cause bear markets. Common reasons for sudden or sharp drops in the market include emotionalism in investor sentiment as well as short-term over-reactions to isolated events.

In the table that follows, 6 of the 10 independent bear markets were less than 10 months long. Only 2 of the 11 recession-connected bear markets were that short.

[Image source]

While some of the bear markets were independent events, all of the recessions were accompanied by bear markets. Focusing on them, we can see that while the bear markets and recessions overlapped, they did not begin and end at the same times.

Economists divide economic data into three categories: leading, coincident, and lagging indicators. The leader in the field is the Conference Board, which took over the U.S. leading economic indicator series from the U.S. Department of Commerce in 1996.

Stock markets are considered leading economic indicators. Indeed, the price level of the S&P 500 is one of the 10 leading indicators in the Conference Board’s Leading Economic Index.

Because stock markets look ahead (or try to), a bear market often starts before a recession begins and ends before the recession ends.

That happened with the Great Recession. The bear market began in October, 2007, three months before the recession began in December. The bear market ended in March, 2009, while the recession did not end until June, 4 months later.

What’s the Best Way to Invest During a Recession?

There is no universal answer to what’s the best way to invest during a recession. It depends on your goals, age, personal situation, and a host of other circumstances that are unique to you.

What I would like to do here, however, is to suggest a framework for thinking about that question.

My overall theme is to think long term if you are in a position to do so.

Here is why I suggest that: Over long periods of time, the overall direction of the stock market has been up.

[Source of all JPMorgan charts]

Of course, some of the short-term down periods have been devastating. On the chart above, the market declines during the Great Depression, World War II, Vietnam War, tech wreck, and Great Recession all stand out as lasting long enough, and/or being deep enough, to cause great distress for many investors.

However, as the chart below illustrates, while bear markets have been painful, market recoveries have been powerful. They have lasted longer and generated far more gains than the losses that preceded them.

[Image source]

The lesson I draw from this and similar data is that if you are invested in the stock market, and if you are able to live with a short-term unrealized loss, stay invested.

As shown in the next chart, 1-year stock market returns (S&P 500) have been very volatile and price-risky when measured over periods as short as one year. But if you expand the period out to three years and beyond, price risk all but disappears.

The key words earlier, of course, were “if you are able to live with a short-term unrealized loss.” History tells us that many investors simply cannot or will not do that.

How Do Investors Generally Behave?

Dalbar, Inc. is known for its studies of investor behavior. Their Quantitative Analysis of Investor Behavior Study (“QAIB”) has been analyzing investor returns since 1994. It has consistently found that the average investor earns much less than market indexes would suggest.

Dalbar issues press releases like this one about average investors during 2018:

The average investor was a net withdrawer of funds in 2018 but poor timing caused a loss of 9.42% on the year compared to an S&P 500 index that retreated only 4.38%.

“Judging by the cash flows we saw, investors sensed danger in the markets and decreased their exposure but not nearly enough to prevent serious losses. Unfortunately, the problem was compounded by being out of the market during the recovery months. As a result, equity investors gained no alpha, and in fact trailed the S&P by 504 basis points,” said Cory Clark, Chief Marketing Officer at DALBAR, Inc. [Source]

The investor flaws identified from Dalbar studies are always the same: Ill-timed trading, selling out as the market drops, and not being in the market during times of recovery. In other words, selling low and buying high.

To measure investor behavior, Dalbar studies money flows into and out of mutual funds. I have some difficulties with using mutual fund flows as proxies for investor behavior, but I think they are sufficient to illustrate broad points.

You’ve probably seen the next graph or its ruder cousin below:

The “Average Investor” bars, showing the average investor underperforming every other asset class graphed, are based on Dalbar’s data based on flows into and out of mutual funds.

As the last recession rolls off the left edge of 10-year charts, let’s remind ourselves of what the S&P 500 has done in those 10 years.

I think most readers would agree that the best thing to have done would have been to just stay invested. And this is true despite the earlier table that shows that there were two short-term bear markets since the Great Recession, in 2011 and 2018.

Instead of staying invested, here is what investors actually did: They pulled money out of the market. Years after the bear market of 2007-09, many investors remain rattled.

[Image source]

That’s a sad image. In only two years did equity funds (including ETFs) collect more money than they redeemed…during a 10-year bull market (interrupted by two brief bears) that has been the opportunity of an investor’s lifetime.

Look at the “Average Investor” graphs more closely. The average investor has underperformed every asset category you can think of (except Asian emerging market and Japanese equities in the 2013 data). They could have improved performance by simply buying and holding any asset class.

The graphs suggest that investor timing has been poor: Selling in the face of falling markets, then failing to re-enter (or buy any investment assets) in time to catch the next upswing.

When they sold, where did the money go? The conclusion appears to be that it went into cash, because cash is not represented on the charts, and everything else beat the average investor.

How has cash done? Money in a savings account has not generated enough return to beat inflation since 2007.

What Stocks Do Best in Market Declines?

Of course, we cannot peer into the future with any hope of accuracy. The market’s behavior is always uncertain.

But we can look to the past for clues about what kinds of stocks have done relatively well in declining markets.

[Image source]

For example, from the above chart, Consumer Staples and Utilities have done better than the market (the S&P 500) in the past eight periods of 15%+ declines. Healthcare and Telecom Services only trailed the market once each.

On the other hand, Materials, Consumer Discretionary, Financials, Info Tech, and Industrials have generally done worse than the market during market declines.

Energy is in the middle, having done better four times and worse four times.

How Dividend Growth Investing Helped Me

I’ve only been a serious investor during two recessions: The tech wreck and the Great Recession. My results during the tech wreck were probably like many investors: I lost money overall, although bond holdings cushioned the blows.

But by the Great Recession, I was discovering dividend growth investing (DGI). And that helped me, because DGI urged me to look not at day-to-day stock prices, but at organic income from owning stocks. By “organic,” I mean that the stocks themselves produce cashflow to the investor via dividends or distributions, as distingished from selling shares to produce cash.

That change in focus – from price to income – meant that I was no longer triggered by what I now consider investing “noise”: Daily price swings, CNBC, IPOs, price charts, interest rates, housing starts, employment rates, and the like. Those things (for the most part) now seem less relevant, too short-term-oriented, and designed to create heat rather than light.

The pursuit of reliable, growing, and “enough” income became paramount. And, what I didn’t expect, that focus had a side benefit that I am only appreciating in the past couple of years: It kept me invested. I wasn’t tempted to sell anything based on one month’s employment data or the myriad other bits of data that bombard investors constantly.

The happy result is that my wife and I have benefited from the entire bull market from March, 2009 to the present day. In our house, the bull market is not the most-hated bull market in history. It’s beloved.

My purpose in writing today is not to steer anyone to dividend growth investing. There are many articles on that subject, and I’d direct you to DGI Lesson 9: My Top 14 Reasons Why Dividend Growth Investing Makes Sense to learn more.

The purpose here is different, as described below.

Closing Thoughts

My reason for writing this article is to urge stock investors to think long and hard about selling out their holdings in reaction to a market slump or a recession.

Try to avoid knee-jerk reactions to financial news and daily/weekly market movements.

Rather, consult your business plan. You have an investing plan, right? If not, you might want to consult DGI Lesson 12: Run Your Investing Like a Business.

Your business plan should contain guidelines or rules about when and why you will sell or trim stocks.

In my own business plan for my public Dividend Growth Portfolio, there are several guidelines for selling. None of them is based on falling prices. That’s because of my focus on organic income.

Whatever your investment focus or model, having a written plan helps you remember, in times of stress, what your goals are and how you intend to achieve them. It helps make you less reactive to market noise, economic data, or panicky headlines.

Stick to your plan when short-term stress rears its head. Don’t be that “Average Investor” who flees the market during a downturn, especially if the fundamental business models of your companies are not really affected by short-term market moves or even by a recession. You may even come to see price drops as opportunities to buy more shares at bargain prices rather than fearsome events to run away from.

Don’t panic-sell. Come up with a solid investing plan that advances your goals, that you can commit to, and that you can stick with when the market turns against you.

I’ll close with a couple of quotes from famed investors Peter Lynch and Warren Buffett.

The real key to making money in stocks is not to get scared out of them. – Peter Lynch

Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market. – Warren Buffett

Thanks for reading, and best of luck with your investing! I hope you reach all of your goals even if there are short-term detours along the way. Keep your eye on your destination.

— Dave Van Knapp

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