Still Waiting on the Recession That is Always Six Months Away

The conclusion of the first quarter of our new year is a good time to recall what has happened from an economic and market perspective.  After all, looking back at what has happened is always easier than guessing what will happen in the future.  Most of the developments have been positive.  The economic indicator on everyone’s minds is inflation and the progress has been good.  After reaching its peak in June of 2022 at an annual rate of 9.1%, the Consumer Price Index (CPI) has been working its way downward and came in at 5.0% in March of 2023. A large contributor to the decrease in overall inflation is the sharp decline in energy prices which have been volatile historically.  If energy prices increase, the overall inflation rate will increase too.

Two main forces are working together to bring down inflation.  First, the Federal Reserve has moved quickly in the last year to raise interest rates.  The Fed Funds rate has gone from 0% to 5% in just over a year, and many other interest rates have followed.  Also, for the first time since the 1980s the supply of money (M2 if you remember your economics class) has been shrinking and taking inflation down with it. So far, the Fed’s plan has worked the way they hoped it would. 

While short-term rates have risen substantially, intermediate-term rates have fallen slightly this past quarter.  The 5-year US Treasury bond rate fell from 4.0% at the end of 2022 to 3.6% on March 31^st, and the 10-year rate fell from 3.9% to 3.5% over the same period.  The scenario we find ourselves in, where short-term rates are higher than longer-term rates, is called an inverted yield curve and has been a good, but not perfect, predictor of recessions.  Of course, it has been inverted for over a year now, and the impending recession always seems to be six months away.

While we have been waiting, we have seen some reasonably good results in the equities markets.  Stocks have risen from the stock market low set on October 12, 2022, and it remains the low point six months later.  Stock market volatility is at its lowest point since 2021. 

The S&P 500 companies paid dividends in 2022 that were 11% higher than their dividends in 2021.  This would seem to indicate that they were still profitable even as the investing public discounted the earnings potential of America’s great companies.

So how do we explain the relatively solid market performance so far this year when every economist is predicting that a recession is inevitable? Furthermore, what should we do if we know (or think we know) that a recession is coming?  What matters in the short to intermediate term is (a) how deep the recession goes in terms of driving down GDP, (b) how long it lasts, and (c) how significantly corporate earnings take a hit as a result of the recession.  Unfortunately, even if we knew that a recession was coming, knowing the details of when, how long, and how deep are supremely unknowable.

What we can know is that, like all recessions, even if it does come it will be temporary.  And we can be sure that secular growth (and marvelous compounding) of the great companies of America and the world is something we can’t miss out on even if participating in the miracle of compounding means holding on during downturns that we think we see coming.

Another thing we can know right now is that even if we don’t know if a market selloff will occur, how long or deep it will last, we know that if it does happen, we will tell ourselves that we saw it coming and we didn’t do anything about it.  Then we will beat ourselves up for “knowing” and not avoiding it.  As time moves forward and turns our tomorrows into yesterdays, the cloudy future becomes the certain past.  It will be very easy to tell ourselves, now that we know what happened, that we knew before it happened.  But we don’t know the future now, and after it all plays out, we still didn’t know until we knew.

If we do want to know what the future holds, the most reliable way to make predictions is over the long term.  Markets have ups and downs and various catastrophes of the month, but they tend to balance out over time.  In the thirty years ending in 2022, the cost of living increased 2.2 times while the S&P 500 cash dividend increased 5.3 times, and the index increased nine times.  You can pick any 30-year time period and the results will be reasonably close.  The problem that most investors are trying to solve for, keeping up with inflation so that they can continue to provide for their needs as costs rise, has a solution and the solution is that equities beat inflation over time.

The best way to have completely missed this opportunity was (and is) fixating on the short to intermediate term randomness of equity prices. Many investors overreact to the equity market’s random and historically temporary price declines.  They sell their long-term equity holdings at panic prices and end up buying them back (if at all) at much higher prices when the panic subsides.

We may be going into a time of turbulence, or we may not be.  If it is turbulent, we won’t know how bad or how long it will be.  But we do know that it will be temporary.