- 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. If you enjoyed this video,
please share it with someone who you think could benefit
from the information. And don't forget, if you run out of Common Sense
Investing videos to watch, you can tune in to weekly episodes of the Rational Reminder podcast wherever you get your podcasts. (upbeat music)
