Economies move in cycles. At the start of a new cycle demand for goods and services is strong and growing. Businesses hire more workers, open new stores and factories, and scramble to increase production. The newly hired workers spend their wages, increasing demand even further. Times are good, everybody pays their bills and the only people suffering are the bankruptcy lawyers.
Sooner or later, growth slows down. Businesses suddenly find that they have new competitors and their selling prices come under pressure. Good employees become hard to find, and the ones that are available want higher wages. New workplaces are harder to find, so rents go up. As selling prices fall and wages and other expenses rise, profits start to decline. Good operators manage, but the weak ones, particularly the under-financed, over-leveraged or inexperienced newcomers, start to fail.
Inevitably, the growth cycle grinds to a halt, and eventually, goes into reverse. Firms close and lay off workers. Store fronts become vacant. Laid off workers have no money to spend, so demand for all goods and services starts to decline. With a surplus of available labour, wages go down, and the vacant stores and factories put pressure on landlords to lower rents. As growth turns negative, suddenly the economy is in recession.
Since the great depression of the 1930s, the major aim of economists has been to try and find ways to interrupt this cycle. Led by probably the greatest economist of the 20th century, John Maynard Keynes, governments learned that increased spending (fiscal policy) could shorten both the length and the depth of a downturn. Monetary theory, pioneered by Milton Friedman, showed that central bankers could both dampen the exuberance of the upward cycle, and reduce the pain of the down cycle by manipulating interest rates and the money supply. The combination of monetary and fiscal policy has reduced both the number of recessions and their magnitude, particularly in the last 35 years. But the business cycle has not been abolished, and recessions are still regarded as more or less certain to occur at some point.
Newspapers and the digital media have elevated fear of the next recession, and in this they are of course aided by our collective memory of the financial catastrophe of 2008/09. That recession has rightly been deemed the Great Financial Crisis; it was the most severe economic downturn since the Dirty Thirties, and naturally, many fear that the next downturn will be just as bad. In our view, this is most unlikely. The excesses that shook the banking and financial industry to the core in 2008 have been largely removed. The huge housing bubble in the U.S. that led mortgage lenders and owners of related securities to realize horrific losses is a thing of the past. There is no noticeable inflation. In short, conditions in 2019 in no way resemble those that presaged the last recession.
Naturally, the main concern for our clients is the impact that the coming recession, whenever it arrives, will have on their portfolios. We know that the stock market and the economy are two very different things, but it is almost always the case that stock market downturns occur before and during recessions. In other words, when the recession comes, stock prices will go down. That is hardly big news. Stock prices go up and down all the time. The real question should be: What long term impact, if any, will a recession have on the value of my holdings? We can find an answer to this question by looking at the two significant recessions in the last twenty years, those of 1998-2000 and of course, 2008-2009.
Here are some the lessons we and our clients learned over those twenty or so years:
- When a recession hits, the tide goes out and all boats drop. Even high quality stocks will go down in price. From September 2008 to March 2009, Royal Bank shares dropped 50%, as did those of Apple. JP Morgan lost 60% of its market value in the same seven months.
- As Warren Buffett famously quipped, when the tide goes out you find out who is swimming without a bathing suit. While all stocks fall at the start, some never come back. Victims of the last recession included famous names such as Lehman Brothers, Merrill Lynch and Washington Mutual as well as dozens of speculative names, now long forgotten except by their bereaved former shareholders.
- Good stocks recover their market value. The higher the quality, the faster the recovery. Only six months after losing half its market value, Royal Bank was up 132% from its low point in March 2009, to a new all-time high. Apple did a round trip from $22 to less than $10 and back to over $22 from September 2008 to September 2009.
- Good quality stocks keep paying their dividends during a recession. During the 2008-2009 period, of the fifty or so stocks our clients owned, fewer than five cut their dividends. Several continued to raise their dividends every year, good times or bad.
- Recessions create bargains. Great companies go on sale at prices that might seem unbelievably cheap in a few years. During late 2008 and early 2009, one could buy Canadian National Railway for $19 (now $123), Apple for $10 (now $212), Amazon for $35 (now $1,822) and Walt Disney for $13 (now $136). Long term shareholders should relish the opportunity to increase their positions in great companies at discount prices. We must always remember that price and value are two different things. During a recession, prices for quality stocks will fall much more rapidly than their real value.
- Selling stocks at the start of a recession is unwise. Selling causes capital gains to be realized and taxes must be paid, reducing available investment capital. Knowing just when to sell is impossible, and knowing when to get back into the market is even harder. One of the absolute certainties of the investment business is that nobody is a consistently good market timer.
All investors are in a constant battle with their emotions. As much as we like to think of ourselves as having nerves of steel and ice water in our veins, rising stock prices fill us with triumphant enthusiasm for risk, and falling markets bring on depression, anxiety, the sense that only darkness lies ahead, and the conviction that all risk is to be eschewed. Recessions are simply part of economic life. Keeping a level head, recognizing economic and market realities and acting accordingly is harder than it sounds. Those who can manage it are well rewarded.
