The recent pullback should have provided a good gut check for investors.
By Brian Tall
In recent conversations, a number of clients have said something to the effect of: “I’m comfortable with an aggressive allocation today, but I want to keep a close eye on any economic indicators that would suggest it’s time to shift more conservative ahead of the next economic downturn.”
The problem with this approach is that capital markets are the leading indicator (since the prices of financial securities incorporate, or discount, expectations about the future into current valuations). By the time the National Bureau of Economic Research (NBER) declares the economy to be in recession (based on incoming economic data), markets are likely to be well off their peak already.
To illustrate, the chart below shows recession start/end dates, recession announcement dates, and the performance of the U.S. stock market from 2007 – 2013:
- On December 1, 2008, NBER announced that the U.S. economy was in a recession that started a year earlier in December 2007.
- The stock market peaked in October 2007, and later declined 38 percent from the official start date of the recession (December 2007) to the date it was eventually announced (December 2008).
- By the time the recession was announced, the stock market suffered most of the losses it would ultimately incur.
- The stock market bottomed out in March 2009, a few months before the recession ended in June 2009, and 18 months before NBER announced the recession had ended.
- The stock market appreciated 27 percent between the end date of the recession and the date it was eventually announced.
- Anecdotally, many observers believed the U.S. was still in a recession as late as 2010 and many feared the recovery was so fragile (based on economic data) that a double-dip recession was highly possible.
- Economic activity occurs in real time, but is reported with a lag.
- Investors anticipate what is happening in real time and value financial securities accordingly.
- When economic data is reported, investors compare their earlier forecasts with actual reported data and revise their future forecasts accordingly.
- When earlier forecasts do not align closely with reported results, there tend to be large market swings.
- The prices of financial securities incorporate expectations for thousands of economic variables. There is not a short list of economic variables that, in turn, can be used to reliably predict market movements.
- While the stock market is considered a leading indicator, it is not necessarily correct all the time. Hence, the saying: the stock market has predicted 9 of the last 5 recessions.
- Clients need to be in an allocation they are comfortable with for the long-term. Markets are very fast moving (as the recent pullback demonstrated) and it is not wise to think you can move ahead of it.
- The recent pullback should have provided a good gut check for investors. If you were uneasy during the downturn, it would be a good time to revisit the amount of risk they are taking and consider adjustments now that we’ve recovered much of the losses.
Brian Tall serves as the chief investment officer at Brighton Jones.
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