Philosopher George Santayana averred that, "Those who cannot remember the past are condemned to repeat it." So let's not forget the past, particularly the recent past for the stock market, which was a test run for investors in what they can expect to see unfold when a recession-minded trade hits home.
To put it bluntly, the stock market tanked in the fourth quarter of 2018 due in large part to trap-door selling in the month of December, which ended up being the worst December since the Great Depression.
At one point, the S&P 500 was down 14.8% in December alone. That low point on Christmas Eve was quite the lump of coal.
Things brightened after that, fortunately, yet the S&P 500 still lost 14% in the fourth quarter.
It is a much different state of affairs today. The S&P 500 has surged 15% from its December 24 low, gaining 7.9% in January alone, making it the best start to a year since 1987!
Yes, Mr. Santayana, we remember what happened in October 1987, but that is beside today's point, which revolves around the market's performance characteristics in the fourth quarter of 2018 when it was doing just about everything it could to price in a recession:
- Oil prices were plummeting
- Gold prices were rising
- Credit spreads were widening
- Counter-cyclical sectors were outperforming and cyclical sectors were underperforming
|S&P 500 Sector||Sept. 28 Price||Dec. 31 Price||Percent Gain/Loss|
- Speculative plays, like bitcoin and cannabis stocks, were collapsing
- Treasury yields were dropping; and
- Cash was king
We can't help but think that Jack Bogle, who pioneered index investing as the founder of Vanguard and who passed away on January 16 at the age of 89, is smiling somewhere right now. Why? Because every index investor just learned the importance of what Mr. Bogle preached: it is foolish to try to time the market.
Mr. Bogle would say to stick to a systematic investment plan and don't panic sell and you'll do just fine in the end because you'll pick up stocks at lower prices and participate in the rebound that will come inevitably.
However, even he might have been surprised by how fast the rebound off the December 24 low has unfolded.
We don't mean to make Mr. Bogle sound Pollyannaish. He wasn't. He was simply practical, which came across in one of the last investing messages he shared in a Barron's interview before his death.
In that interview, Mr. Bogle said he sees "clouds on the horizon," and cautioned that investors should cut back on their exposure to stocks to reduce risk, saying, for example, that someone with a 70%-30% stock-fixed income allocation might want to consider something like a 60%-40% stock-fixed income allocation.
Notice he didn't say to get out of the stock market altogether -- nor would he. That wasn't his investment style.
A Bad Time
Some today might be thinking Mr. Bogle was off the mark with his cautious-minded call. In hindsight it's easy to argue this, especially after how the market moved after believing it got carried away with recession fear.
Nevertheless, the history of the stock market is rich with periods of good times and bad times. Fortunately, there have been more good times, which is why the bad times really stand out when they hit.
The fourth quarter of 2018 was one of those bad times. Why it unfolded in the rapid-fire fashion that it did remains open for debate.
We have suggested it was one part technical, one part fundamental, and in large part psychological, which is to say the investing crowd allowed itself to get carried away with the recession narrative, which got reinforced with the price action inside and outside the stock market.
The way in which cyclical sectors were trading, bonds were trading, oil prices were trending, and flows to money market funds were accelerating made it seem as if a recession was just around the corner, which in market terms equates to sometime in the next six months.
That's looking like a somewhat outlandish view considering the price action seen to begin this year. Still, a lot of highly-respected CEOs and money managers are mentioning the "R" word and allowing for the possibility that it could happen as early as next year.
A Recession Is Coming... Some Day
The best call on the recession matter was made by JPMorgan Chase CEO Jamie Dimon, who said last May in a Bloomberg TV interview that the odds for the next recession are 100%. The only unknowns, he quipped, were when and why there would be a recession.
In the fourth quarter of 2018, the market was pinning the growing probability of a recession on the Federal Reserve and its hawkish-minded monetary policy. How quickly things change.
In a matter of weeks, the Federal Reserve has pivoted from foe to friend with a soothing acknowledgment from Fed Chair Powell on January 4 that the Fed would be paying close attention to market signals and would be patient with its policy approach. That message was reiterated this week and Mr. Powell also volunteered that the Federal Reserve's balance sheet normalization effort could be ending sooner than expected.
There is still plenty to fear with respect to the economic outlook, but the Federal Reserve is no longer in that mix, with the exception perhaps of the lagged effect of prior rate increases kicking in now to impede growth.
Otherwise, the clouds on the horizon include high levels of corporate debt, the specter of the U.S. and China not working out a trade deal, and foreign economies succumbing to self-inflicted wounds like China reining in excess speculation, Western Europe dealing with Brexit, and Japan raising its sales tax.
It has not gone unnoticed either that the Conference Board's Leading Economic Index has declined in two of the last three months and that the 82.3-point gap between the Present Situation Index (169.6) and the Expectations Index (87.3) for the Conference Board's January Consumer Confidence Index marked one of the widest readings on record.
A CNBC.com article highlighted research done by Bespoke Investment Group that indicates recessions weren't far behind when that gap has exceeded 50 points. The only three times it was wider than 82.3 points, meanwhile, was January through March 2001, according to Bespoke Investment Group. Yes, Mr. Santayana, we remember that a recession started in March 2001.
We're not suggesting a recession is just a few months away, yet DoubleLine Capital's Jeffrey Gundlach is calling the gap between current conditions and expectations "the most recessionary signal at present."
What It All Means
So, if a recession is on the horizon, how does an investor prepare for it? One need only look to the recent past for an answer.
The recession-minded trade in the fourth quarter of 2018 may have been a head fake, but it was informative nonetheless because it revealed the prevalent trends in a recession-minded trade.
Treasuries, gold, and cash did well; counter-cyclical sectors did relatively well; cyclical sectors did not do so well; junk bonds were junked; oil prices sank; and the funny-money speculative trades got clobbered when the market turned serious.
Is your investment portfolio ready to weather the next recession-minded trade, which will happen before the recession itself actually happens?
If you don't know the answer, just look above to find it -- and remember, those who cannot remember the past just might be condemned to outsized losses in the next recession-minded trade without proper diversification.