Investors fear “Market Corrections” and often equate them to “Economic Recessions,” but as you’ll read in this article, the two are not the same. In fact, one can occur without the other. The third investor fear is ”High Inflation.” In the following we discuss each fear, its current threat, and how to protect against it.
The National Bureau of Economic Research (NBER) defines a recession as “a period of falling economic activity spread across the economy, lasting more than a few months.” The NBER is the private non-profit that announces when recessions start and stop. It is the national source for measuring the stages of the business cycle. In other words, we have a “recession” when the NBER says we have a recession. That said, the common, unofficial, definition is a decline in GDP growth that lasts 2 quarters or more, which has occurred in the first two quarters of 2022. Concisely, a recession is a reduction in economic activity. The American economy shrank an annualized 0.9% in Q2 2022, following a 1.6% drop in Q1, meeting the unofficial definition of a recession.
A market correction is defined as a 10% drop in a stock market index, and the S&P 500 is the customary index for this determination. A market correction is also known as a bear market. The S&P 500 dropped 20% in the first half of 2022, but then recovered 9% in July, so it’s down 13% YTD, remaining below the 10% threshold definition of a correction.
High Inflation, also known as Galloping Inflation, occurs when prices increase by more than 10% in a year. Increases in the Consumer Price Index (CPI) for all goods is the common measure of price increases. By contrast, Hyperinflation is much more serious, and is defined as a price increase of 50% or more in a month. Inflation in June 2022 is 9.1% as measured the CPI but alternative measures like Shadow Government Statistics (SGS) is twice CPI at 18%
Cause and Effect
There is some debate about whether recessions cause market corrections or market corrections cause recessions. The data favors the latter – market corrections cause recessions – because bear markets have generally preceded recessions. Some say that stock market behavior is a leading indicator of economic activity, but this is mostly semantics. Reductions in wealth caused by market corrections trigger less spending, which slows economic activity. Dr. Robert Haugen was among the first to identify this causality. Here’s the history of the sequence of bear markets relative to the start of recessions:
According to The Balance, recessions cause:
- Increase in unemployment (16,000 jobs were lost in 2008)
- Consumer purchases fall off
- Businesses go bankrupt
- People lose their homes (Home prices fell 10% in 2008)
- Young graduates cannot get a good job
A recession becomes a depression if it lasts two or more years.
As the Federal Reserve moves to stabilize the economy with fiscal and monetary stimuli, inflation can result, as it did in the 1970s when the US suffered from “StagFlation”, the word for economic stagnation combined with high inflation .
The Fed is trapped in a cycle that will not end well. If it causes a “Taper Tantrum” as it did in 2013, it might re-initiate its Zero Interest Rate Policy (ZIRP), but this requires money printing that will fuel inflation fires.
There are reasons to believe that the US economic slowdown will continue for a long time, as discussed in “Now You Know… the Rest of the Story”.
According to economist Robert Dieli, the triggers for a recession are:
- Instability introduced by a shock, like retaliation from a rogue nation like Iran or North Korea, or a dirty bomb.
- Sustainability of a slowdown, like the current squeeze on supply chains associated with COVID and the Russian war
- The Fed may have used up all of its ammunition for averting a recession. Interest rates are going up because a negative 7% real rate cannot last.
CNBC recommends these 6 defenses.
- Don’t panic. Make sure that you have the risk capacity and horizon to weather the storm.
- Take stock of your personal life. Is your job secure? Can your family live without an income for a reasonable time?
- Make a plan. How will you react to the next recession
- Move to cash. This is very much a market timing decision.
- Don’t run up your credit cards. You may find that you can’t pay them off.
- Recognize that recessions are not the end of the world.
The primary effect of a market correction is investors become poorer because they lose money. Consequently, they spend less, so economic growth slows. The consumer is key to economic growth.
There’s one group of people who suffer the most from a market correction – those who are in transition from working life to retirement. This group has their lifetime savings at risk. There are 78 million Baby Boomers in the Risk Zone. Losses in the Risk Zone result in reduced standards of living and a reduction in the length of time that savings last, even if markets subsequently recover.
There are two distinct groups of target date funds: Safe and Risky. Most TDFs are in the Risky group, ending 85% in risky assets – 50% in equities plus 35% in risky long-term bonds. By contrast the Safe group is 70% in safe assets at the target date, and currently comprises just three funds: The Federal Thrift Savings Plan (TSP), The SMART Target Date Index and the Office and Professional Employees International Union (OPEIU). As shown in the following, the Safe group has protected in 2022.
Stock Market Bubble
Through December 2021 the US stock market enjoyed the longest recovery on record, exceeding 13 years. US stocks returned 600% over the past 14 years, bringing Price/Earnings ratios above 30, as contrasts to an average P/E of 15. US stocks were awfully expensive.
High prices generally precede a market correction, but sometimes prices continue to rise for a long time, as they did in the “Growth Bubble” of the late 1990s. The mantra of the 1990s was “the trend is your friend.” Today it’s FOMO – fear of missing out.
No one knows when the next correction will occur or how deep it will be. It’s like the shifting of tectonic plates. We know it’s coming. There will probably be a catalyst like a natural disaster or a flare-up from the world’s debt crisis, discussed in the next section on Inflation. 2022 might mark the beginning of a stock market crash.
The best defense is moving to safety, like US Treasury Bills and Treasury Inflation Protected Securities (TIPS). For many this move is market timing, which most agree is hard to do right because entails a second decision, namely when to get back in the market.
For some this move is “risk management” rather than market timing. People in the Risk Zone should be protecting their assets regardless of their market outlook. By protection we mean 70-80% in Treasury Bills and TIPS. Once they’re safely through the Risk Zone investors can plan to re-risk to extend the life of their savings.
But there’s another consideration. Treasury Bills will not be a safe investment if we suffer serious inflation rendering cash less valuable. Inflation is our next topic.
Inflation undermines the purchasing power of what is called “fiat money,” namely cash. A loaf of bread would cost 50% more following a 50% rise in inflation, but most don’t believe inflation can exceed 13% because that’s as high as it has ever been. In Inflation, When Art Thou, Professor Craig Israelsen suggests that historical inflation ranges set the bounds for future ranges, but that’s just not true. A few years ago, the Cato Institute released its working paper on “World Hyperinflations.”
How bad can inflation become? The Cato Institute working paper examines the 56 occurrences of hyperinflation across the globe. The worst of the worst was 200% per day in Hungary from August 1945 to July 1946.
Many believe that we will see serious inflation around the globe because we cannot afford the humongous debt we’ve incurred. Inflation benefits the borrower at the expense of the lender.
Per capita world debt has soared above $200,000. The world economy is running on the fumes of delusory borrowed money, playing an outlandish game that will not end well. We owe each other money that won’t be paid in today’s dollars. That’s why crypto currencies were invented. Fiat money only works if we all agree to honor it; otherwise, it’s just pieces of paper. US currencies were debased in 1971, when they were taken off of the gold standard and replaced by “In God We Trust.” Now debasing means printing money, or monetizing the debt. Lenders lose when borrowers control payment values.
The major countries are the most broke, namely the US, China and Japan. The US is even more broke that you think. Signs of weakening credit quality are also appearing in China, where 2018 and 2019 were record years in corporate bond defaults.
What’s worse is that the US government has printed more than $13 trillion in the past decade, outstripping the costs of our biggest wars.
Source: Congressional Research Service
“You cannot fix a problem that you refuse to acknowledge.” ― Margaret Heffernan, Willful Blindness: Why We Ignore the Obvious at Our Peril
Sticking our collective heads in the sand and hoping the problem goes away is not a solution. But no politician who wants to stay in office will acknowledge the problem and deal with it. They want to delay the day of reckoning, but this delay cannot be indefinite. We need to protect ourselves because our leaders will not.
Treasury bonds will not provide the safety that they have historically offered because they’re at the heart of the problem: financing the debt. A well-diversified portfolio of inflation-protected assets will help, like Treasury Inflation Protected Securities, commodities, and real estate.
There will always be life events to which we each react in our own ways. Since we only get one life path, each decision is particularly important. Today’s decisions weigh heavily on our future, so it’s important to have a lifetime investment plan that puts today’s decisions into perspective.
There’s plenty to keep us all awake at night, but that’s a good thing. We need to be prepared for the worst, and grateful for the best.