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| Stephen High |
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| Richard Flohr |
Whenever headline news from the financial media screams recession, many investors react by selling stocks. Clients of Kraft Asset Management understand the importance of remaining steadfastly diversified according to their unique risk profile rather than attempting to chase -- or flee -- returns. Patience is the key to achieving your long-term objectives.
Still, practical investment methodology can be sorely tested when the reality of a recession actually hits, and you may find yourself tempted to join an exodus. To test whether this is a good strategy, consider equity premiums -- that is, the extra (premium) returns over “risk-free” investing -- surrounding the past 11 recessions.1
During recessions
The general equity premium has actually been positive on average during recessions (0.20 percent per month). Thus, even if you had somehow known a recession was about to begin, there would have been no good reason to move from stocks to bonds.
Following recessions
The premiums gained during the six months following recessions have been significantly more than the losses suffered during the six months preceding recessions (1.69 percent versus -0.35 percent per month for general equities). Because it’s impossible to predict the timing of a recession, it would seem the prudent course is to stay the course throughout.
Small-cap and value risk premiums
What about remaining within equities, but shifting to less risk by moving from small-cap/value to large-cap/growth? Our analysis of shifting from small-cap to large-cap during recessions indicates the move would generally have been a wash. And there is no indication that value stock premiums were affected by the recessions one way or another; therefore, there would have been no reason to move in and out of value in reaction to the news.
In short, while the data indicates that stock prices may provide early indications of where the economy is headed, the reverse is untrue. You cannot rely on the state of the economy to indicate where the stock market is headed. If anything, by selling out of stocks during times of weak economic performance, you are more likely to miss out on substantial gains that may follow a recession than to benefit from seeking “safe harbor.”
Fortunately, another key element within KAM’s investment methodology -- disciplined rebalancing -- helps clients continue to seek long-term growth throughout erratic markets. During bear markets you can rebalance by buying stocks “low” to raise your equity allocation to its appropriate level. During bull markets you can sell stocks “high” to reduce your equity allocation to its appropriate level.
Buying low and selling high
Sounds simple. The hard part is ignoring all the noise and emotions surrounding you, and actually carrying out the strategy. One of our most important roles as a fee-only advisor is to help our clients do just that.
1 “Recession” as defined by the National Bureau of Economic Research (NBER) is “a significant decline in economic activity spread across the economy, lasting more than a few months.”
Data Sources: Asset class returns cited herein are based upon the following indexes (per asset class):
S&P 500 (U.S. large), Russell 1000 Value (U.S. large value), Russell 2000 (U.S. small), Russell 2000 Value (U.S. small value), MSCI EAFE net dividends (intl. large), Fama-French International Value (intl. value), MSCI EAFE Small Cap price only (intl. small), Dimensional International Small Value (intl. small value), MSCI Emerging Markets Free Index gross dividends (emerging markets), Fama-French Emerging Markets Small (emerging
markets small), Fama-French Emerging Markets Value (emerging markets value), Wilshire All REIT (real estate), and Dow Jones AIG Commodities (commodities). Asset class premiums calculated using Center for Research in Securities Prices (CRSP) and Fama-French databases.
Article reprinted with permission of BAM Advisor Services, Inc.
