Like many working people in the service sector these days, I’ve been working from home three days per week until my 6-year-old daughter is back in school (someday).  Zoom meetings are now the norm, as are face masks and air hugs.  It’s a typical week when we’re dropping off groceries or meals at the door of friends who are quarantined.  And vacations are stay-cations.  To say there’s been a paradigm shift would be the understatement of the year.

Economically speaking, 2^nd quarter GDP declined 9.3%, far worse than any other decline in history.  Entire sectors of the market has been decimated: travel, entertainment, retail, energy, and commercial real estate to name a few.  Other sectors had this pandemic fall into their laps: technology (especially software), online retail, healthcare, and solar energy for example.  Do you think online meeting and home fitness equipment companies would have seen their stocks triple over the last 5 months without COVID?  I don’t think so.

So when people ask me if I think the market will go up or down, I ask them, “Which market are you talking about?”  The S&P 500 is back to its prior highs set in February, but not all 500 stocks are back to break-even for the year.  In fact, it’s a handful of strong stocks that has risen the index back to its previous levels.

But if we’re in a recession, doesn’t it make sense for the market to ultimately go down?  Is March 23^rd really the ultimate low of this recession that dwarfs 2008 in its severity?  How can the S&P 500 possibly be going up when the economy is looking so horrible?

In prior commentaries, I discussed the huge impact of government stimulus and intervention, so I won’t rehash that here.  But this seeming contradiction between a stock market rally and negative GDP isn’t unique.

Let’s take a look at all 30 recessions of the last 150+ years.  It might surprise to you learn that not all bear markets are accompanied by recessions and not all recessions are accompanied by bear markets.  In fact, there have been 16 recessions which had positive stock market returns as measured from the start and end of each recession.  They lasted 16 months on average and returned anywhere from 0.7% to 38%, with an average return of 9.8% and an average GDP decline of -3.0%.[1]

The recession of February 1945 – October 1945 returned 38.1% and had a GDP decline of -12.7% and -16.6% annualized.  When you look at all 30 recessions since 1869, there’s actually a -0.05 correlation between GDP growth and stock market returns.  In other words, recessions and stock market returns aren’t related!

We understand the desire to want to avoid large drawdowns because those do happen.  It can be tempting to try and time the market to avoid any kind of loss.  But if you do the math, in order to beat a “100% invested 100% of the time” strategy over that 150-year period, you would have ad to successfully predict a whopping 77% of the market turns.  Wow.

So what is the right strategy to limit long-term loss?  I say long-term because regardless of an allocation, short-term losses will happen if you’re invested in anything besides a savings account.  Long-term loss is created by two things: buying high and selling low, and buying weakness and holding it too long.  Here’s how to avoid those two things:

1. Don’t play the contrarian. It’s a misnomer to think you can buy something that’s being dumped by everyone else and make money doing it.  It doesn’t matter how undervalued something is.  If people aren’t buying it, it doesn’t matter what it’s worth.  Just look at airlines and cruise lines.  They’re certainly trading for less than they’re worth, but there’s no buying interest.  If you buy them now, you could be waiting a long time before they turn into winners.
2. Buy into strength. You want as many tailwinds as possible when investing, so follow the flows.  Go into the companies that are leading in the pack in sectors that are leading the market.  Find companies that are actually growing their earnings during recessions.  They won’t be immune to short-term losses, but they are more likely to fair better during downturns because they’re the stocks investors will probably want to keep.
3. Set selling criteria ahead of time. Not all strong companies stay strong forever.  Set objective criteria for when to fold.  It may be earnings related or sector related.  It may be a certain percentage decline in the price.  Whatever it is, create them ahead of time so you aren’t making emotional decisions in the moment.
4. Have a running buy list. When you sell a stock, you need to replace it.  Keep a list of companies that have beat their earnings and are in strong sectors.  For lessons on how to do that, I recommend using Stockcharts.com or Morningstar.com.

To recap, the best timing strategy is no strategy at all.  Stay invested at your proper risk tolerance with a portfolio diversified around strength.  That’s the secret to investing success.

[1] *Source: William Madden and Adam Field, “U.S. Stock Markets During Recessions”, Russell Investments Research, November 2019.

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