- 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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